By Shreenivas Kunte, CFA, Adjunct Faculty – Incharge Trade/Research Lab, S.P. Jain Institute of Management & Research
Ever since India’s general election results on May 16, expectation on effective governance from the new government has been a central driver for the markets to rally. While the government’s ability to steer policy and deliver on governance is expected to be the biggest catalyst for growth, changes that the last government notified in the corporate sector through the Companies Act could play a critical role as well.
India’s Company Act 2013, effective from April 2014 (most parts), is set to significantly alter and bring in changes for a better corporate governance environment in India. The section on independent directors, in particular, is among the biggest corporate governance change that the new law is set to address.
The 2013 Companies Act has given independent directors a larger role in the board. The number of independent directors has been set to a minimum of one third of the board strength. Independent directors are now required to hold at least one separate meeting in a year without the participation of non-independent directors. To enhance scrutiny, companies are now required to have audit committees with independent directors forming a majority. To aid impartiality, independent directors are restricted in terms of continued vesting of benefits. For example, stock options have been disallowed and a holding cap of voting shares has been set to 2%. India’s Securities and Exchange Board (SEBI, securities regulator) has further strengthened the independent director’s focus / impact by restricting the number of boards that an independent director is able to serve to 3 (for listed companies) and by putting an upper limit of 10 years to the maximum tenure that the independent director can serve on the board.
Independent directors strengthen the corporate governance framework through independence and objectivity. Their expertise and out-of-the-corporate box views are expected to improve management action and their oversight is expected to avoid undue risk taking. Independence and objectivity that the independent directors bring to the board is especially important in India where a high promoter holding (more than 30% promoter holding) is seen to scuttle minority shareholder interest. A high promoter holdings shields management decisions from scrutiny. Some of the significant corporate actions (mergers, dividends) in a high promoter holding world have been criticized for the disadvantage they bring to the minority shareholder (Maruti,Ambuja). Improper usage of cash/assets, mergers being used to favor promoter holding stake, have all been in the news. While independent directors may not be able to prevent pure fraud (Satyam, Enron, Worldcom), the Act seeks to equip the independent directors with powers to make the company management more accountable. An independent director’s resignation (in protest of a corporate action), the clout that one third voting rights independent directors have, their role in audit committees, are significant roadblocks for impropriety.
Data on NIFTY companies for the last five years (source: courtsey Bloomberg, S P Jain Inst of Mgmt), shows that the average percentage of independent directors on company boards, has remained above a healthy 50%. NIFTY companies with the highest independent director representation include, Dr Reddy’s (80%), HCL Tech (71.4%), Wipro (76.9%), Mahindra Motors (76.9%) and HDFC (71.4%). Predictably, NIFTY companies with the lowest independent director representation on company boards include four public sector corporations (GAIL, BHEL, BPCL and NMDC).
As the graph above (Exhibit 1) indicates, a capweighted index of companies with the highest independent director representation has returned 321% vs a NIFTY return of 180% over the last five years. On the other hand, the return for a basket of NIFTY companies with the lowest independent director representation, has been, 170%.
While the average independent director representation for NIFTY companies has been beyond the minimum required by law (one third), the enhanced role for independent directors that the new law seeks to bring, can bring a considerable, positive change to both corporate governance and market impact.
– S K