A recent notification by SEBI has abolished the position of Nominee Directors in Public listed companies. Until few years back, reports and articles suggested that Nominee Directors should be independent directors. Then what bought about the change? And whether the same is effective and for good? These are some of the questions which will be analyzed in this project along with the role of Nominee Directors in the light of Corporate Governance.
The phenomenon of nominee director has become an important feature of the modern Indian corporate scene. This is primarily because of the role of the various lending institutions like banks, mutual funds, public financial institutions, state financial corporations, etc. These lending institutions have assumed a pivotal role in the modern corporate world financing the various projects of the companies also as the monetary commitments by these institutions are high it is but natural that they would want to safeguard their interests. Besides they would also like to ensure that the money is used for the stipulated purposes only.
A look at the concept of nominee director would reveal that this concept has a serious drawback – it being the conflict of interest and division of loyalty that a nominee director has to face on the hand being a representative of a institution and on the other hand being the director of a company and the duties and liabilities that come with it.
Nominee directors as a concept exists worldwide, Institutional investors put them on the board of a company where they have put in substantial amount of their money thereby assuring themselves that there is somebody in the board who will take care of their interest and see that their money is being invested in places were it ought to be.
Thus, before talking about Nominee Directors, let’s first examine the role of Institutional Investors. There are two views with regard to the role that an Institutional investor should play in the corporate governance system of a company one primarily saying that institutional investors should interfere and the other view stating to the contrary.
The reasoning given for non interference of institutional investors is that the institutional investors have the primary fiduciary responsibility of taking care of those people who have invested in their institutions thus their involvement in the board/ management of a company will lead to a conflict of interest. Another reason advanced for non-interference of institutional investors is that they are not competent enough to interfere in the companies’ management.
Those who believe that institutional investors should take an active part in the management of a company strongly believe that it is ideal for an effective corporate governance system in a company the institutional investors should take part in the management of the company. The Cadbury committee (1992), for example, states that “because of their collective stake, we look to the institutions in particular, with the backing of the Institutional Shareholders’ Committee, to use their influence as owners to ensure that the companies, in which they have invested, comply with the code”. In India the Kumaramanglam Birla committee report with regard to the role of investors, it similarly emphasizes their role in the management of the company.
Institutional investors usually invest in companies who follow good governance standards as it is usually found that companies with a good governance record usually have recorded better financial performance standards than those who have got poor governance records. It has been seen that the value of the stock returns of companies who have corporate mal-governance is lower than those companies who have good governance practices. The reason that can be attributed for the fall in the value of the companies who haven’t maintained good governance standards can be two fold.
The fall of value of the company can firstly be attributed information irregularity caused by corporate mal-governance. It results in information getting lop sided thereby bringing down the value of the capital assets issued by the company. The other reason that is attributed to the lowering of value of a company because of poor governance standards is that it increases the agency cost. Thus institutional investors invest in only those companies who maintain proper governance standards thereby insuring that the value of their portfolio doesn’t get reduced.
Now, moving on to what Nominee Directors are, they have been defined as '... persons who, independently of the method of their appointment, but in relation to their office, are expected to act in accordance with some understanding or arrangement which creates an obligation or mutual expectation of loyalty to some person or persons other than the company as a whole.
Nominee director could be representative of a major shareholder, a class of shareholders or debenture holders, a major creditor or an employee group. This situation of mutual expectation of loyalty to some persons or group of persons happens when the government, foreign collaborators, holding companies, financial institutions or other lenders etc., nominate a director to represent there interest in the board.
The right to nominate directors on the Boards of the financed companies is usually contained in the contract itself. However, the special legislation governing certain ‘public financial institutions and State financial corporations’ envisage the appointment of certain directors on the Boards of the financed companies and such a provision has an overriding applicability in spite of the normal regulatory provision of the companies act, the Memorandum of Association and the Articles of Association.
Except where a statute provides for nomination of directors on the Board of a company, nominee directors can be appointed only if a provision to that effect exits in the Memorandum of Association or Articles of Association. It is to be noted that in case of statutes governing certain statutory financial institution they are empowered to appoint nominee directors.
The Guidelines for appointment of Nominee Directors in companies were issued by the Ministry of Finance, Department of Economic Affairs vide its circular in March 1994. As per this circular, IDBI, IFCI, ICICI and IRBI were required to create a separate department/cell whose exclusive and whole time function would be to represent the institutions on the Board of Companies. The circumstances under which nominee directors can be appointed are:
(i) where the institutional holding is more than 26%
(ii) where the institutional stake by way of loans/investments exceeds Rs. 5 crore
(iii) where a unit is running into problems and is likely to become sick.
A problem with regards to appointment of Nominee Directors is that the person who is elected to be a nominee director of a company is usually an employee or from a panel of professionals from various disciplines maintained by them. What is needed is a person with professional attitude and capability of taking commercial decisions. Nominee directorship should not be a post retirement benefit to retired executives or bureaucrats. The nominee director depending upon his status and ranking in the financial institution he represents makes a lot of difference in the response he gets from the management.
“One of the senior and experienced officers of a financial institution was nominated as director on a leading and prosperous chemical company belonging to a larger house in India. In the mid-70’s the company wanted to diversify in to shipping and a proposal was made to acquire a ship. The nominee director was of the opinion that shipping industry was a cyclical industry and prone to wide fluctuations and in the foreseeable future such a proposal was not in the company’s interest. However he could not counter persuasive arguments of a leading tax luminary on board as also the charming personality of the chairman. Ultimately, the venture resulted in a loss and the company gave up shipping industry.”
Nominee directors tend to reveal two opposite tendencies at Board meetings. Either they tend to play safe or fiddle around to make their presence felt by including in a long monologue. If a company is passing through lean times they tend to be cynical of the management and their attitude seem to be fault finding rather than fact finding. They tend to show questioning attitude rather than an enquiring mind.
‘Corporate Governance’ as defined in the Cadbury Committee Report is “the system by which companies are directed and controlled. Board of directors are responsible for the governance of their companies. The shareholders’ role in governance is to appoint the directors and auditors and to satisfy themselves that an appropriate corporate governance structure is in place. The responsibility of the board includes setting up the company’s strategic aims, providing the leadership to put them into effect, supervising the management of the business and reporting to shareholders on their stewardship. The Board’s actions are subject to law, regulations, and shareholders in general meeting.”
In the report of Confederation of Indian industry, the need for corporate governance in India was stated. It is thus summarized: Firstly, there is a unique structure of Corporate Governance in the developed world. The corporate governance code of each country has to be designed keeping in view the peculiarities of the country. Secondly, Indian companies, banks and financial institutions can no longer afford to ignore better corporate practice. With integration of India into the world market, companies will be required to give greater disclosure, more transparent explanation for major decisions and better corporate vale. And thirdly, corporate governance extends beyond corporate law. The quantity, quality and frequency of financial management disclosure, the extent to which the Board of directors exercise their fiduciary responsibilities towards shareholders, the quality of information which the management share with their boards, and the commitment to run transparent companies that maximize long term shareholder value evolve due to catalytic role played by the more progressive elements within the corporate sector and enhance company law.
Thus the CII code states that “corporate governance refers to an economic, legal and institutional environment that allows the companies to diversify, grow, restructure and exit, and do everything necessary to maximize share holder value. Corporate governance is an interplay between companies, shareholders, creditors, capital market, financial sector institutions and company law. Hence, a code of corporate governance must address all these issues.”
Thus corporate governance means the total functioning of the company and the conduct of business internally and externally and embraces the complete accountability of the management and the Board of Directors to the shareholders and the wider public.
Corporate Governance deals with laws, procedures, practices, and implicit rules, that determine a company’s ability to make managerial decisions vis-à-vis its claimants—in particular, its shareholders, creditors, the State and the employees. Successful corporate governance lies in balancing the various conflicting interests and interest groups i.e. investors, creditors, employees, government and society at large.
EXPERT COMMITTEE REPORT
CADBURY COMMITTEE REPORT
In the late 1980s the corporate sector in UK was inundated with a number of problems. While companies had grown in size, it was not matched by correspondin growth in accounting controls. These involved creative accounting, spectacular business failures, the limited role of auditors, the weak link between executive compensation and company performance and several others. Also the growth in size of the corporate was not matched by change in the pattern of Board which had become smaller. It was under these circumstances that the Cadbury committee was setup by the Financial Reporting Council, London Stock Exchange and the accountancy profession to address particularly the financial aspects of corporate governance.
The Cadbury committee report laid great stress on the role of institutional investors in maintaining the corporate governance standards of the company. The reasoning given by the committee is that they take care of those people who have invested their money in their institutions and whose money has been loaned to the company to support their finances.
The Cadbury Committee gave three points which would insure a smooth relationship between the company and there owners.
1. Institutional investors should encourage regular, systematic contact at senior executive level to exchange views and information regarding strategy, performance, Board membership and quality of management.
2. Institutional investors should make positive use of there voting rights, unless they have good reason for doing otherwise. They should register their votes wherever possible on a regular basis.
3. Institutional Investors should take a positive interest in the composition of Board of directors, with particular reference to concentration of decision making power not formally constrained by appropriate checks and balances and to the appointment of a core non-executive director of the necessary caliber, experience and independence.
Thus we see through the above given three points that the Cadbury Committee is very much in favor to the presence of the institutional investor in the board of a company. They want that the institutional investor with all the power they hold should place a nominee director on the Board of the company or be in regular contact with the company management so as to insure that the company stays on course and to insure the continuous upliftment of the corporate governance standards.
CII’S REPORT ON CORPORATE GOVERNANCE IN INDIA
Unlike South-East and East Asia, the corporate governance initiative in India was not triggered by any serious nationwide financial, banking and economic collapse also, unlike most OECD countries, the initiative in India was initially driven by an industry association, the Confederation of Indian Industry (CII) this was India’s first foray into corporate governance.
In December 1995, CII set up a task force to design a voluntary code of corporate governance. The final draft of this code was widely circulated in 1997.In April 1998, the code was released and was called the “Desirable Corporate Governance: A Code”. Between 1998 and 2000, over 25 leading companies voluntarily followed the code: Bajaj Auto, Hindalco, Infosys, Dr. Reddy’s Laboratories, Nicholas Piramal, Bharat Forge, BSES, HDFC, ICICI and many others.
The CII committee report analyzed the concept of nominee director in detail. The committee has drawn a parallel of the working of nominee director as it exits in India and countries like Germany, Japan and Korea and stated that “even though in effect they have the same combined debt cum equity positions so common to German, Japanese and Korean forms of corporate governance. But these informed insiders in India do not seem to behave like there German counterparts; corporate governance and careful monitoring do not seem to happen as they are supposed to when a stakeholder is both creditor and owner of equity, as in Germany.”
The Committee has in its report outlined the major sore points which has led to the apparent failure of Government controlled FI’s to monitor companies in there dual capacities as major creditors and shareholders. The committee says that the problem lies in the anti-incentive structure. The problems outlined are thus:
1. Major decisions by public sector financial institutions are eventually decided by the Ministry of Finance, and not by their board of directors. De jure, this cannot be cause for complaint after all the Government of India is the major shareholder and, hence, has the right to call the shots. However, at issue is the manner in which the government calls the shots, and whether its decisions enhance shareholder value for the FIs.
2. Nominee directors of FIs have no personal incentive to monitor their companies. They are neither rewarded for good monitoring nor punished for non-performance.
3. There is a tradition of FIs to supporting existing management except in the direst of circumstances. Stability of existing management is not necessarily a virtue by itself, unless it translates to greater transparency and higher shareholder value.
4. Compared to the number of companies where they are represented on the board, the FIs simply do not have enough senior-level personnel who can properly discharge their obligations as good corporate governors.
Concluding there observations the committee stated that “it is because of these faults that these nominee directors who ought to have been more powerful than the disinterested non- executive directors are in fact at par”. The committee looking for a solution says that “the solution requires questioning the very basis of majority government ownership of FI’s and thereby questioning as to whether its time that the government should become a minority shareholder in the in all its financial sector institutions”.
The committee gave the following recommendation with regard to Nominee Directors:
Recommendation No. 17
Reduction in the number of companies where there are nominee directors. It has been argued by FIs that there are too many companies where they are on the board, and too few competent officers to do the task properly. So, in the first instance, FIs should take a policy decision to withdraw from boards of companies where their individual shareholding is 5 percent or less, or total FI holding is under 10 percent.
It is felt that the CII committee on corporate governance has confused between the functioning of the institutional investors as it takes place in countries like Germany, Japan and so on and the functioning of institutional investors in our country. In India usually the Financial Institutions are creditors of the company and not shareholders. Money is lent to the company and a contract is signed wherein the posting of a nominee of the FI’s on the board of the company is also agreed to. Whereas in countries like England, Australia, New Zealand, the Institutional Investors have a investment portfolio and an equity portfolio wherein when they loan money to a company they also usually take shares of the company in return thereby becoming shareholders of the company in which they have invested there money. This does not happen in India, and the investors here occupy the position of creditors and not shareholders.
KUMARMANGALAM BIRLA COMMITTEE REPORT
The report of Kumarmanglam Birla Committee on corporate governance with regard to nominee directors stated “there is another category of directors in Indian companies who are the nominees of the financial or investment institution who are present in the board to safeguard the institutions’ interest. The nominees of the institution are often chosen from among the present or retired employees of the institution or from outside. In the context of corporate governance there should be arguments both for and against the continuation of this practice.
Those who favor this practice argue that nominee directors are needed to protect the interest of the institutions who are custodians of the public funds and who have high exposures in the projects of the companies both in the form of equity and loans. On the other hand there is an inherent conflict when institutions through their nominees participate in board decisions and in their role as shareholders demand accountability from the board.”
The committee taking into consideration arguments both for and against nominee directors thus recommended
1. When companies are well managed and performing well, the need for protection of institutional interest is much less than when companies are badly managed or underperforming. The committee therefore, recommended that the institutional investors should appoint there nominee directors on a selective basis wherein such right is pursuant to a right under a loan agreement or where such appointments is considered necessary to protect the interest of the institution.
2. When a nominee of the institution is appointed as a director of the company, he should have the same responsibility, be subject to the same responsibility as any director of the company. They committee also gave the concept of the Chinese Wall that is if the nominee reports to any department of the institution on the affairs of the company, the institution should ensure that there exits a Chinese Wall between such department and other departments which may be dealing in the shares of he company.
NARAYAN MURTHI COMMITTEE RECOMMENDATIONS
There is some uncertainty with regard to the status of nominee directors in light of the latest committee on corporate governance. The Naryan Murthi committee on corporate governance with regard to nominee directors has stated, “The Committee felt that the institution of nominee directors creates a conflict of interest that should be avoided. Such directors often claim that they are answerable only to the institutions they represent and take no responsibility for the company’s management or fiduciary responsibility to other shareholders. It is necessary that all directors, whether representing institutions or otherwise, should have the same responsibilities and liabilities.”
The report further stated that “If the institution, whether as a lending institution or as investing institution, wishes to appoint its nominee on the Board, such appointment should be made through the normal process of election by the shareholders. The Committee noted a dissenting view that FI nominees should not be granted any Board representation rights. Management should treat them on par with other investors and disseminate the same information that other shareholders would obtain. By virtue of their Board seat, FIs are placed in an advantageous position over the other shareholders, in terms of company price-sensitive information.
Thus the committee made the following mandatory recommendation:
There shall be no nominee directors.
Where an institution wishes to appoint a director on the Board, such appointment should be made by the shareholders.
An institutional director, so appointed, shall have the same responsibilities and shall be subject to the same liabilities as any other director.
Nominee of the Government on public sector companies shall be similarly elected and shall be subject to the same responsibilities and liabilities as other directors.
A perfect starting point can be the decision of the House of Lords in Scottish Cooperative Wholesale Society Ltd v Meyer .
In the present case Lord Denning talked about the concept of nominee director at length and said that “So long as the interests of all concerned were in harmony, there was no difficulty. The nominee directors could do their duty to both the companies without embarrassment, but as soon as the interests of the two companies were in conflict, the nominee directors were placed in an impossible position. It is plain that, in the circumstances, these three gentlemen could not do their duty to both the companies, and they did not do so. They put their duty to the co-operative society above their duty to the textile company in this sense, at least, that they did nothing to defend the interests of the textile company against the conduct of the co-operative society. They probably thought that as nominees of the co-operative society their first duty was to the co-operative society. In this they were wrong. By subordinating the interests of the textile company to those of the co- operative society, they conducted the affairs of the textile company in a manner oppressive to the other shareholders”.
The decision thus contains a very clear statement that nominee director’s duties were owed to the company in whose Board they had been placed and not the party they were representating and that their powers and discretions were to be exercised in the interests of that company in preference to the interests of their representatives.
In Australia there seems to be a more relaxed standard regarding the doctrine of undivided loyalty. An appropriate stating point could be the case of Levin v Clark here Justice Jacobs took a wider view and accepted the existence of sectional interests on the corporate board. He said: “It may be in the interests of the company that there be upon its board of directors one who will represent these other interests and who will be acting solely in the interest of such a third party and who may in that way be properly regarded as acting in the interests of the company as a whole the fiduciary duties of directors spring from the general principles, developed in courts of equity, governing the duties of all fiduciaries agents, trustees, directors, liquidators and others and it must be always borne in mind that in such situations the extent and degree of the fiduciary duty depends not only on the particular relationship but also on the particular circumstances.”
Here the circumstance were that the Articles of Association named two directors as governing directors whose powers would only arise when the plaintiff defaulted on the mortgage. This was inserted to protect the mortgagee’s interest when default arose. Justice Jacobs reduced the concept of ‘undivided loyalty’ further in the case of Re Broadcasting Station 2GB Pty Ltd He found that the nominee directors were likely to follow their appointer's wishes but considered this acceptable so long as they do not knowingly sacrifice company's interest for those of their appointer. This has added questions as to whether these nominee directors can be held as constructive trustees when faced with the knowledge of their appointers. Justice Jacobs also relaxed the duty to avoid a conflict of interest situation. He said: “I do not think it sufficient for relief that they have put themselves in a position where their interest and the duty which they have taken directly upon themselves may conflict.”
In New Zealand, the case of Berlei Hestia (NZ) Ltd v Fernyhough can be taken as a starting point. In this case the judgment was delivered by Mahon J he said: “As a matter of legal theory, as opposed to judicial precedent, it seems not unreasonable for all the corporations to be able to agree upon an adjusted form of fiduciary liability, limited to circumstances where the rights of third parties vis-à-vis the company will not be prejudiced”.
Thus we see that situation here with regard to loyalty and conflict of interest is relaxed. The situation being that if the company adjusted the standard of fiduciary duties then directors need not be liable if they have divided loyalty.
Insider Trading means the buying or selling of a security by someone who has access to material, nonpublic information about the security.
Nominee directors may bring to the board table prestige, expertise and knowledge, which can benefit the company. Yet their dual or multiple fiduciary responsibilities to their other companies may inevitably lead to conflicts of interests. These problems are likely to increase as businesses become bigger and more international. Large multinationals already hold commanding positions across a variety of markets and industries. Multi-national companies have an impact on many foreign governments and the international economy. The director who is a nominee of a substantial shareholder is between the devil and the deep blue sea. The doctrine of undivided loyalty and conflict of interest are two burdens on him. A nominee director of a particular institution is always faced with the problem of whom to serve.
Let’s take an example wherein a board meeting has just been concluded and in the meeting discussions were going on as to what will be the next project of the company. The project that the company is planning to undertake is very risky in nature and could lead to major devaluation of shares of the company in the share market and could also lead to the company incurring losses. What should the nominee director do here? The information that he has received because of his being a director in the company is price sensitive and passing on this information to the institution which is a third party to the entire process can lead to him being charged under the Insider Trading regulations .
If we look into sec 2(e) of the enactment that defines an insider we see that it says that insider means any person who is or had been connected with the company and had access to unpublished price sensitive information. Thus the act of a nominee director of leaking an unpublished price sensitive information of the company which had been passed on to him as a trustee of the company can land him in trouble under Sec 3(ii) of the Regulations wherein passing of such kind of information is strictly prohibited. But if he follows all this and doesn’t alert the institutional investor of the risky decision that the company is planning to start the whole purpose of a nominee being sent to the Board to look after the institutions interest are nothing but a waste of time.
Nominee directors as a concept exists worldwide, Institutional investors put them on the board of a company where they have put in substantial amount of their money thereby assuring themselves that there is somebody in the board who will take care of their interest and see that their money is being invested in places were it ought to be. As the nominee director is a member of the board he is required to act as per the duty laid down for a director, but herein we find that they are in dual capacity with a responsibility to secure both organizations’ interest. Sometimes there may be a conflict of the two interests consequentially questioning the loyalty of a nominee director. Thus the question before us is whether there is any need for nominee directors in the present world.
When an investor invests money in a corporation, he expects the board and the management to act as trustees and ensure the safety of the capital and also earn a rate of return that is higher than the cost of capital. In this regard, investors expect management to act in their best interests at all times and adopt good corporate governance practices. Nominee directors are appointed by these financial institutions because they feel reassured that there is someone on the Board of the company which has taken the loan, who will secure there interest. But what actually happens is that half the time the nominee is caught in a wrap of loyalty and conflicting interest. For him on the one side there is the company to whom he is a trustee and on the other side is the organization who has nominated him to be the director in the company to safeguard there interest. Caught in this wrap, the nominee director may find himself in a catch 22 situation and as a result may end up being a mute spectator.
Nominee Directors are appointed to safeguard the interest of the investors. The committee report of CII laid down the corporate governance principles and stressed on the point of long term shareholders interest and of the investors. Now in the light of SEBI notification, they have been abolished from Public listed companies. It lead to situation where all companies which are listed, and have investments from various leading FIs would be able to work at their whims and fancy, without the concern of the world and may even take steps which in ordinary course of business would be very dicey. In such a situation, although the company is just having a strategic movement, the investors, whose money is involved in the company cannot do anything to safeguard their interests.
In an article published in the Hindu Business Line says ‘Let Nominee Director Stay.’ The reason given in Narayan Murthy committee report for abolishing Nominee directors are not sufficient. It speaks of a feeling among the members that such an arrangement creates a conflict of interest which, it goes on to add, should be avoided. Implicit in this is the belief that the principle of a conflict of interest is so apparent and by extension indefensible as to need any reiteration. But that is far from the case. The recommendation that SEBI direct listed companies not to have such nominees (as part of listing conditions) is not practical as financial institutions are mandated by governmental directives to have such nominees on boards of large industrial undertakings to which they have lent money or have investment exposure in. Unless these institutions are privatized, they would continue to be dictated by such directives and incorporate nominee directorship clause in the financial arrangements that they enter into with listed companies.
Another reason is that Nominee Directors lead to insider trading. Insider trading is often equated with market manipulation, yet the two phenomena are completely different. Manipulation is intrinsically about making market prices move away from their fair values; manipulators reduce market efficiency. Insider trading brings prices closer to their fair values; insiders enhance market efficiency.
Insider trading appears unfair, especially to speculators outside a company who face difficult competition in the form of inside traders. Individual speculators and fund managers alike face inferior returns when markets are more efficient owing to the actions of inside traders. This does not, in itself, imply that insider trading is harmful. Insider trading clearly hurts individual and institutional speculators, but the interests of the economy and the interests of these professional traders are not congruent. Indeed, inside traders competing with professional traders is not unlike foreign goods competing on the domestic market –the economy at large benefits even though one class of economic agents suffers.
Even if restrictions on insider trading were considered desirable, their sound implementation is extremely expensive. A wide variety of individuals can be classed as insiders by virtue of possessing information material to securities prices –top management, upstream and downstream producers, regulatory and enforcement authorities, professional advisors, etc. Further, the universe of associates through whom insiders could route their trades is very large –family, friends, business associates who are "paid" in information, etc. Enforcement of restrictions upon insider trading runs the risk of either being ineffective or being a witch-hunt. Even if there are pockets of high quality enforcement, they would not appear fair in an environment where insider trading is otherwise rampant.
What the Narayan Murthy committee reports states is that the investors should become shareholders and then as they no more would be a third party, they could appoint institutional director. As they are now part of the company, they would have equal right to information. Thus prima faci, it solves the problem of insider trading (if there is any) and any other problems with the functioning of Nominee Directors, but practically it just legalizes the entire concept of Nominee Directors again. Meaning for example, if the investor holds a large chunk of shareholding and then a director is appointed by the shareholders, it would also lead to the same position as that of a nominee director. After all, such institutional director would also work for the benefit of the shareholders and majority of whom, in the present instance are investors. It thus is a new and refined word for nominee directors, but will almost have the same type of working as nominee directors.
As eminent columnist Sucheta Dalal rightly says “we in India can forgot about legally mandated board reform. Our regulators are too timid to force such drastic change on Indian companies.”