Corporate governance practices are in a continuous state of evolution, particularly in a developing economy such as India. It is argued that corporate governance practices in India are an imperfect emulation of western practices, particularly of the Cadbury Committee Report, and subsequently, the UK Corporate Governance Code and the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”). While arguably, Sarbanes-Oxley was a knee jerk reaction to corporate accounting frauds by corporate managers of Enron, WorldCom and Adelphia Communications,[1] the Cadbury Committee was occasioned in particular by the sudden financial collapse of two companies, Wallpaper Group’s Coloroll and Asil Nadir’s Polly Peck consortium.[2]
While the United Kingdom and the United States of America seemed to take corrective action in the wake of the economy-damaging corporate frauds, India has adopted a more pre-emptive stance to combat corporate misdemeanors. Though no law can preemptively eradicate every form of illegality it seeks to address, as is evident from scams such as Satyam, imposition of appropriate supervisory models may largely decrease such instances.
This article examines whether a supervisory corporate management system in the form of a “supervisory board” may be necessary to preempt the effects of corporate greed and neutralize impact of “moral hazard”.
Current legal framework in India
The Indian Companies Act, 1956 and the listing rules of the stock exchanges currently guide the composition of the board of directors on Indian corporations. Indian law mandates a one tier board system. The board of companies whose securities are listed on the stock exchanges must be comprised of atleast 50% independent directors, if the chairman of the board is an executive director. In cases where the chairman is a non – executive director, the minimum number of independent directors on the board goes down to 1/3rd of the total number of directors on a board. For unlisted companies (whether public or private), there is no requirement to appoint any independent directors on the board[3].
Framework for the supervision of corporate management
Corporate boards are predominantly divided into one-tier boards and two-tier boards. Within Europe, the United Kingdom adopts the single board system consisting of executive and non-executive directors. The United States of America follow the monistic board structure as well. On the other hand, Germany traditionally employs the dualism of a management board and a separate supervisory board. This dual system is also found in the Netherlands, Austria, Finland and Denmark.[4]
The structures and legal frame work governing one-tier boards need little elaboration. Most jurisdictions adopting this framework insist on an optimum combination of executive and “outside” or “independent” directors on the board of a company. These “outside” or “independent” directors are expected to be unconnected to the company, its promoters and its majority shareholders.
What is a two tier board system?
The German Stock Corporation Act, 1965 envisages a two–tier board structure comprised of the management board and supervisory board. Comprised entirely of executive directors, the management board is responsible for managing the enterprise and its day to day operations. The supervisory board appoints, supervises and advises the members of the management board and is directly involved in decisions of fundamental importance to the enterprise.[5] The supervisory board’s more important functions include approval of the annual accounts of a company and initiating court actions against the board members. A maximum of half the members of the supervisory board are elected by the shareholders at the general meeting of the company.[6] The supervisory board is entirely comprised of non – executive directors.
The supervisory board, in many ways, is superior to the management board as it has the power to appoint and supervise the management broad. The company is truly controlled by its stakeholders with executive directors taking up the role of traditional senior managers rather than directors.
Strengths and weaknesses of the dualistic system
Reduction of information asymmetry between the board and the shareholders
There exists an information asymmetry between shareholders and the board of directors. The directors take “inside decisions”, the genesis of which is unknown to the shareholders. These “inside decisions” affect the value of the shareholders’ investments in the company. When a model enumerated by the German Stock Corporation Act, 1965 is followed, where the representatives of the shareholders are appointed to the supervisory board, the presumption leans towards the reduction of information asymmetry.
The fallibility of this two-tier system in a country like India could be due to the nature of Indian corporations. Ordinarily, Indian companies are closely held family concerns. A large majority of the shares of a company are held by a single or a connected group of shareholders. Under such circumstances, the shareholder’s representatives on the supervisory board may not be truly independent. Also, some of the members of the supervisory board are nominated by the creditors of the company and clearly, they would not be categorised as independent directors.
However, with India opening up its borders to most multinational conglomerates, there could be a presumption that, over time, the Indian corporate scenario may witness a higher number of widely held corporations. Introduction of two-tier boards as an option for widely held companies could align regulatory foresight to this flux.
Reduction of the negative impact of moral hazard
As a concept, “moral hazard” is the situation where a person takes risks because the negative impact of those risks would not be felt by him personally. The decisions of corporate managers are immune to scrutiny in the absence of fraud and gross negligence. Hence, there may be occasions where managers tend to be less careful about their decision making processes if they themselves are not affected in any way by the result of their decisions. A supervisory board would supervise all important decisions proposed to be taken by the management board. Also, as shareholders’ representatives, the supervisory board would ensure that such decisions are consistent with the interest of the shareholders. Moreover, the ability of the members of the supervisory board to institute court actions against the executive directors would drastically reduce moral hazard.
Most businesses require the directors to utilise foresight in taking certain business decisions which at that point may seem aggressive. In the event that the supervisory board does not share the vision of the executives, then in their conservative attempt to maintain shareholder value, there may prove to be a stalemate leading to an unworkable situation.
Attractive proposition for reputed investors
Appointment on marquee names on the supervisory board of a company lends immense confidence to shareholders. This allows a company to attract investment as well as boost such investor confidence.
As a minor persuasion, reputed personnel on the supervisory board may also significantly reduce transaction costs. Most foreign private equity or other investors insist on inclusion of stringent risk allocation tools within their investment agreement, once they decide to invest in Indian companies. There would be a greater presumption towards a company’s ability to general positive cash-flows with established managers on the supervisory board advising and supervising the activities of the management board. Consequently, transaction costs would reduce as a result of shorter and more passive negotiations.
Structural weaknesses of the two–tier board system
The independence of the members of the supervisory board due to the separation of the control is the reason for a number of structural weaknesses.
The exercise of power of the supervisory board is mostly reactive, which decreases the “quality” of its control. Consequently, the system reduces the possibility of the occurrence of the same mistake, rather than preempt an error.
Information asymmetry between the two boards: There is a strong presumption that complete information about a company’s day to day business activities and future plans would only be available with the management board. There exists, in most cases, an information asymmetry between the management and the supervisory boards. As filtered information is received by the supervisory board, there is a possibility that deficiencies may remain undiscovered.
Customising the two–tier system for India
Possibly, the largest deterrent to introduction of the two-tier board system in India is possibly due to Indian companies being predominantly closely held. Closely held companies with a single or single group of shareholders holding a significant majority of the shares would ensure that such majority’s representatives would hold majority of the board positions on the supervisory board as well.
The German model could be suitably modified for India. One of the possible changes that could be adopted is that the financial statements would have to be confirmed and finalised only on the review and approval by the minority shareholder’s representatives. Also, the minority shareholder’s representatives could institute legal proceedings against the directors in the face of gross negligence and fraud. However, the admission of such proceedings before the Company Law Board[7] or any other forum should not be used as an arm twisting tool and should be subject to stringent controls.
[1] See “Much Ado About Nothing: Looking Past the Drama of the Sarbanes-Oxley Act and Reevaluating the U S Delisting Trend among Non-U.S. firms” – Kalani A Morse
[2] http://www.jbs.cam.ac.uk/cadbury/report/index.html
[3]The Indian Companies Act 1956 is under the process of being replaced by the Indian Companies Act, 2013 (2013 Act). Certain sections of the 2013 Act have been notified and are currently effective. However, the provisions pertaining to the board of directors are yet to be notified. The provisions on the composition of the board of directors under the 2013 Act mandate the appointment of independent directors on the board of unlisted companies as well.
[4] See “The German Two-Tier Board: Experience, Theories, Reforms” in Klaus J Hopt and others (eds), Comparative Corporate Governance: The State of the Art and Emerging Research
[5] Section 5.1.1 of the German Corporate Governance Code
[6] See the German Corporate Governance Code: “In enterprises having more than 500 or 2,000 employees in Germany, employees are also represented in the Supervisory Board, which then is composed of employee representatives to one third or to one half respectively. For enterprises with more than 2000 employees, the Chairman of the Supervisory Board, who, for all practical purposes, is a representative of the shareholders, has the casting vote in the case of split resolutions.”
[7] The Company Law Board is a quasi-judicial authority that decides on matters arising out of disputes or breaches of company law in India. It is established by statute and largely excludes the jurisdiction of regular civil courts in India.
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