Are independent directors really independent?

In accordance with the Companies Act 2013, all listed companies are required to have independent directors (IDs) who represent one third of the total number of directors.

Independent directors are expected to represent an impartial and impartial voice on the board. Due to this function, IDs are considered to be the guardians of minority shareholders. However, trust in independent directors could be misplaced.

Perverse incentives

The biggest obstacle to “independence” is the high compensation paid to independent directors. While the Securities Exchange Board of India (SEBI) has caps on directors’ fees, companies often bypass these caps by paying commissions.

Often, fees constitute a large part of the director’s income. No director would kill the goose that laid the golden eggs by going against the management or the promoters.

For example, an infrastructure company, whose boss has used shareholders’ money to fund personal projects in the past, has independent directors who are paid between Rs 60 and 70 lakh per year as compensation.

Considering the substantial income earned through relatively low effort (a few board meetings), most independent directors did not report corporate governance issues and poor investment / acquisition decisions. in the business.

Although these directors hold directorships in other companies, the fees received through this mandate constitute a substantial part of their income, according to data available in the public domain.

Another tactic used by companies is to hire retired government bureaucrats as independent directors. The movement achieves two objectives. First, it helps businesses leverage the network and the power these bureaucrats often wield. Second, current bureaucrats are unlikely to disturb the company in the hope that they will have a comfortable job after retirement.

Several ex-bureaucrats sit on the boards of the largest Indian companies, earning several times what they officially earned as public servants.

Recently, institutional investors decided to dismiss an ex-bureaucrat, who is an independent director of a conglomerate. Despite having worked in the past to protect the rights of shareholders, the director now supports decisions that disadvantage minority shareholders. Self-interest, without any exposure to the negative consequences of decisions made, clearly blurs the capacity for introspection.

An imperfect selection process

The selection procedure for independent directors is generally biased. In Indian companies run by promoters, promoters are careful to invite reliable directors who will never dissent. Boards of directors are usually filled with friends and families of promoters, which makes it even more difficult to have a truly independent voice.

The promoters, who usually hold the majority of the voting rights, decide who gets a seat on the board of directors. The average length of service of a director is 8.2 years, which implies high job security if one complies with the expectations of promoters.

If a director raises too many objections, he will not be re-elected to the board of directors and other companies will not touch him. On the other hand, a director who willingly passes all resolutions will be re-elected and likely recommended to the boards of other companies looking for directors.

No skin in the game

A quick study of the annual reports of the largest Indian companies shows that independent directors rarely own shares in companies. The shares they own are usually obtained through stock option grants. The interests of directors in the company seem to be limited only to the huge salaries they receive.

Therefore, independent directors are unlikely to view the company from a shareholder perspective, which is supposed to be part of their job.

A global perspective

The problem is not limited to India. Even Warren Buffett has pointed out the problems several times in his annual reports. In his 2004 annual report, he wrote: “In our opinion, based on our considerable experience on the board, the least independent directors are likely to be those who derive a significant portion of their annual income. fees they receive for their term on the board (and thus hope to be recommended for election to other boards and thus further increase their income). Yet it is precisely the members of the board of directors who are most often described as independent.

In 2020, Buffett commented on the irony of being an independent director, “the director for whom the fees are important – in fact, sought after – is almost universally classified as ‘independent’ while many directors with very high fortunes. related to the well-being of the company are considered to lack independence ”.

Buffett’s statements clearly show that self-interest often takes precedence over moral obligations. The lack of skin in the game, combined with the need to make more money, made “independent” directors quite unhealthy dependent on their work.

A director receives a larger commission if profits rise but has a safety net if business deteriorates. Such perverse incentives have created a “yes” culture in most boards.

The model of the independent director leaves a lot to be desired. In addition, the current model does not really judge “independence” correctly. In this scenario, investors would be better off sticking with executives who have made shareholder-friendly decisions in the past, rather than relying on independent directors.

Independent directors start resigning after someone else reports the issues – a trend seen in most corporate scams. Minority investors are truly alone and must act accordingly.

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