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Nitin Potdar

Why two-tier board structure is suitable for Indian companies

27 June, 2017

If mere compliance was the litmus test of corporate governance, there is little wrong with the Indian situation. On the face of it, all listed Indian corporates have the Securities and Exchange Board of India (SEBI)-specified governance structures and independent directors in place. But as often is the case with governance across spheres, mechanised compliance invariably proves to be self-defeating. Corporate governance is no exception. No wonder, India has become the cesspool of umpteen management mishaps—including the recent debate on the management style of an Indian IT giant—which has made effective corporate governance in India a distant, if not utopian, dream.

The root cause analysis demands no rocket science, and it’s quite apparent that the Achilles’ heel is the weak and inadequate authority of the so-called independent directors. It is high time SEBI introduced a two-tier board system for Indian companies—that is, supervisory board and management board.

This is not to undermine SEBI’s efforts to arrest the falling standards of corporate governance in the specific context of promoter-driven Indian companies. Way back in 2003, SEBI had constituted the NR Narayana Murthy committee in 2003 for remedial recommendations. (It is ironic that the chair of that very committee has had to face widespread embarrassment over the alleged weak governance of his brainchild.) SEBI subsequently introduced a comprehensive chapter on ‘corporate governance’ under Clause 49 of the listing agreement which dealt with the appointment of independent directors, as also their participation in the remuneration and audit committee. The new Companies Act, 2013 adopted many of the provisions of Clause 49 of the listing agreement and has defined the term ‘independent director’, outlining his/her role via the Schedule IV of the Companies Act. Although SEBI’s initiative was indeed laudable, the mandatory provisions knowingly or unknowingly overlooked harsh realities specific to India. For one, most Indian promoters of the ‘family’ tradition act as gang lords, a worst kept industry secret.

History is replete with instances when unyielding promoters in many cases have not allowed the management and the independent directors to perform their respective roles in letter and spirit. Secondly, and more importantly, Schedule IV has pointlessly linked the role of independent directors with that of management functions.

Consequently, independent directors often invite needless litigation over offences emanating from poor management decisions.

A single tier system needlessly puts independent directors and executive directors at loggerheads, as their mandated roles push them into the red zone of conflict. No wonder, independent directors are penalised for no fault of theirs. And when we seldom have independent directors and executive directors on the same page, overriding promoters at times prove showstopper with their adamant attitude and bulldozing tactics.

If the role of independent directors needs to be distinguished from the management, it is imperative to follow the two-tier system. Founders (holding not more than 2%) can productively share space with independent directors in the supervisory board, given their limited economic interest. Many founders can certainly find a secure shelter in the supervisory board to play the role of meaningful ‘mentors’ to respective managements.

Two-tier board unplugged
Two-tier boards enable stakeholder inclusion better than one-tier ones. Given the stakeholder-focussed model, employee and environment interests are automatically considered. Workers are entitled to participate in strategic discussions and can recommend supervisory board members as they deem fit. Proper demarcation ensures effective and impartial control. To reduce management influence, the supervisory board can include an adequate number of independent members. Likewise, the appointment of former management members ensures critical contextual knowledge.

Of course, the two-tier board come with its own set of inadequacies. Information asymmetry is one grey area where supervisory board may lack adequate insider business knowledge. But the inherent weaknesses are certainly curable.

The supervisory board’s right to inspect corporate documentation in person coupled with well-defined board practices for data collection and delivery could considerably reduce information asymmetry. It should necessarily be composed of capable members who receive regular training and with the zest and zeal to study the given company in and out.

Learning by example: the German way
Within Germany’s mandatory two-tier structure, the executive directors of the management board (Vorstand) decide the company’s objectives and implement necessary measures. There are no non-executive directors in the management board. Meanwhile, the non-executive directors in the supervisory board (Aufsichtsrat) monitor these decisions on behalf of other parties. Members of the management board cannot serve as members of the supervisory board and vice versa, but the supervisory board may consist of, for example, representatives of the company’s employees and external managers.

Corporate management in Germany is further governed by the codetermination system. Codetermination requires that a certain proportion of supervisory board’s member must be elected by employees. The influence of such representatives on the composition of management board ensures the protection of employee interests.

India vs Germany: a study of contrasts
• In India, there’s a mandatory requirement of a managing director, whereas the presence of supervisory board in Germany negates this requirement.

• Indian laws do not make a clear distinction between the functions and duties of executive and non-executive directors, unlike German laws. In the latter case, appointment, remuneration and removal of the management board are governed by the supervisory board. However, no such regulation is allowed in single-tier boards.

• Key management decisions are approved by the supervisory board in Germany, unlike India. Back home, only key management decisions are subject to shareholder approval.

• Employees participate in the appointment of supervisory board members in Germany while there is no such provision in the Indian structure.

Exploding myths and misconceptions
• The mere presence of non-executive and independent directors on single tier boards is often erroneously held synonymous with a shift in favour of the two-tier system. But given the high probability of bias among board members (which is eventually manifested in the promotion of private interests and instances of corporate scams) such assumptions can prove foolish and hence fatal.

• The two-tier board system is often disparaged as being archaic and cumbersome, given the delay in management decisions pending approval of the supervisory board. The delay notwithstanding, two-tier boards are more effective in supervision and control over management board. They bring in more stability for the organisation through better supervision and control.

The long and short of it
It is clear that the German model is apt for an India roll-out. This emulation would undoubtedly go a long way towards cleansing the Indian corporate environment. In India, given the rampant instances of insider trading, corruption and lack of transparency, there is an acute need for an impartial supervisory body to protect the interests of shareholders and employees. Then alone can we think of motivating Indian promoters to translate the ornamental mottos glued to boardroom walls, adorned with over-chewed words like honesty, fairness, transparency and accountability, into positive action on the ground.

Nitin Potdar is M&A partner at J. Sagar Associates. Views are personal.

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Why two-tier board structure is suitable for Indian companies

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