Independent directors: an analytical comparison of international standards - II

The European Commission has formally invited Member States, through its non binding Recommendation, to reinforce the presence and role of "independent non-executive directors" on listed companies' boards with the objective of protecting shareholders, employees and the public against potential conflicts of interest.
A director is considered "independent" when free from any business, family or other relationship - with the company, its controlling shareholder or the management - which might jeopardise his or her judgement. When the appointment of a director is proposed, his or her other significant professional commitments should be disclosed.
These are clear guidelines that demonstrate how important it is to determine if the directors are in fact "independent" and any relevant disclosure to their "independence". The OECD principles of Corporate Governance suggests that "Boards should consider assigning a sufficient number of non-executive board members capable of exercising independent judgement to tasks where there is a potential for conflict of interest."
However, it does not specify the number of "independent directors" that should be nominated at a Board. It provides some guidelines as to who should be regarded as an "independent director". This includes affiliations, close relations of the management and company's past employees as persons that may be excluded as "non independent directors".
The principles rely greatly upon the country's individual corporate governance Codes by suggesting that "In defining independent members of the board, some national principles of corporate governance have specified quite detailed presumptions for "non independence" which are frequently reflected in listing requirements." The principles state, "Where there is a party in a special position to influence the company, there should be stringent tests to ensure the objective judgement of the board."
OECD principles rely mostly upon individual country's own listing rules that enforces Code of Corporate Governance in individual countries. Yet there is no denying the fact that emphasis has been placed upon a sufficient number of independent directors and that independence would be compromised if the said director acts under the influence of a significant shareholder or its appointee. This is the most important aspect of the OECD Code of Corporate Governance.
The above analytical review reveals that there is strong emphasis that the majority of directors should be "independent" in any board structure. This principle has changed the board structure in developed economies and therefore, in the United States, the percentage of outside directors on boards has risen to 78% in 2000, up from 66% a decade earlier. This represents an increase by almost a fifth.
The California Public Employees Retirement System (CalPERS), the largest institutional pension fund in the US, argues that the only company executive on the board should be the chief executive and all others should be non executive "independent directors". This is a very stringent test for investment by the pension fund. A similar thinking is gaining strength in the United Kingdom where a majority of company directors feel that a higher proportion of non-executive directors, who are "independent directors", should be appointed to achieve better performance.
A concept is also developing in various countries that would ensure that only those companies should be listed who meet the good governance criteria including the appointment of "independent directors". A consensus is also developing that before any interim or long term funding is provided, the financial institutions would pay special attention to this area of Corporate Governance. Similarly, pension funds would hesitate to invest in those companies that are not complying with good corporate governance principles.
The corporate compositions in Asian countries, especially in India and Pakistan are structured on "family owned controlled" companies. This is a strong binding relationship. Therefore, the test of independence in these "family controlled companies" is not easier to assess.
However, efforts are being made to minimise the impact of relationship in the corporate structure of these companies through changes in the Listing Rules to ensure presence of adequate number of "independent directors" to enhance investor's confidence. This might be a lengthy journey to travel, before satisfactory results are achieved.
In India, the Listing Rules Clause 49, requires that the board of directors shall have an optimum combination of executive and non-executive directors with not less than fifty percent of the board of directors comprising of non-executive directors and, further, that where the Chairman is a non-executive director, at least one-third of board should comprise of "independent directors" and in case he is an executive director, at least half of board should comprise of "independent directors".
The said Clause also sets out the principles for determining "independent director". The definition of "independence" is also linked to the remuneration of directors: Independent directors are those who do not derive the majority of their current income from the company and are therefore not beholden to it for their own financial well-being.
Independence consists of the feeling of freedom to express personal views in the boardroom and the freedom from undue influence by the top management team or the controlling shareholder. Therefore, the Asia might find it difficult to identify truly "independent directors" for years to come.
Similarly, we have extracted from the Annual Report 2006 of a "government owned company" of India. In compliance, it states that "it is a Government Company within the meaning of section 617 of the Companies Act, 1956 as the President of India presently holds 89.5% of the total paid-up share capital. As per Articles of Association of the company, the powers to appoint Directors rest with the President of India.
In terms of the Articles of Association of the Company, strength of our Board shall not be less than four Directors or more than twenty Directors. These Directors may be either whole-time functional Directors or part-time Directors. As on 31st March 2006, the Board comprised twelve directors, out of which six were whole-time functional Directors including the Chairman & Managing Director.
Two directors are nominees of the Government of India. The Board also has four "independent directors" who have been appointed by the Government of India through a search committee constituted for the purpose."
The company is an example that even being a government controlled company; directors are appointed through a search committee. This procedure seems to be transparent and free from cronyism. Therefore, the directors selected through this process may fall under the category of "independent directors" as they may not owe any allegiance to a single authority and there seems to be no possibility of their summarily removal.
Therefore, it seems, India is making efforts to bring in "independence of directors" into its corporate culture even if the company is owned by the government of India. This is in line with the rest of developed world.
In Pakistan, there is hardly any change in the attitudes of companies that are "family owned". Their entire Boards are composed of "non-independent directors." They may have "non-executive directors" on their boards, but again they are family members or ex-employees. No serious effort has been made by the Exchanges to encourage the private sector to gradually comply with the Code relating to the appointment of "independent directors."
If the Code is not taken seriously, there would be hardly any company listed on Pakistani exchanges that would meet the criteria of "independent directors". It is being feared that with the gradual privatisation of government owned companies, the public sector would disappear soon, where at least some progress should have been noticed in this respect.
There too, the "director's independence" remained doubtful due to the alleged abuse of nominating process. The Listing Rules contains Code of Corporate Governance under section XI Para 37 of Karachi Stock Exchange. The Code suggests that all listed companies shall encourage representation of independent non executive directors, including those representing minority interests on their Boards of Directors. It further suggests under sub clause (b) that each listed company includes at least one "independent director" representing institutional equity interest.
It has further been explained in the Code that the expression "independent" means a director who is not connected with the listed company or its promoters or directors on the basis of family relationship and who does not have any other relationship, whether pecuniary or otherwise, with the listed company, its associated companies, directors, executives or related parties.
The "test of independence" principally emanates from the fact whether such person can "reasonably be perceived" as being able to exercise "independent business judgement" without being subservient to any apparent form of interference.
If we review the suggestions' expressed under the regimes of other country's Code of Corporate Governance, it may arguably be concluded that the requirements under clause (b) above under Pakistani Listing Rules, seems to be self contradicting.
Any director that represents an "institutional equity interest" or appointed on behalf of a "minority interest" may not fall under "independent" category as the said director is representing an interest of an institution or a group, which has financial relationship with the company and therefore, may not "reasonably be perceived" as being able to exercise "independent business judgement".
In this case, there should be specific determination of the Board, why it thinks such a director is an "independent director." The UK Combined Code of Corporate Governance is specific on this issue and excludes any director that represents a significant shareholder as "independent director," unless determined by the Board. Other Codes too suggests that such a relationship demands "special explanation" as to why a director is "an independent director" under these conditions.
The Pakistani current listings rules are flawed at least in three areas as far as the appointment of "independent directors" are concerned. Firstly, the Listing Rules do not specify the minimum number of "independent directors" as suggested by other Codes.
Secondly, the Rules do not ask for a determination by the Board that why a particular director is deemed to be an "independent director" if one is representing an institution or a group of investors, and thirdly, the Rules do not ask any other disclosures, if a particular director has any other interest that may be relevant to determine him as an "independent director".
Currently, the impression among the corporate circles is that any "non-executive director" may be called an "independent director", which is evident from the following Annual Report 2007 of a leading bank in Pakistan.
Out of the 23 listed compliance's of the Code, only three compliance's relate to the appointment of "independent directors" and these are being reproduced below with the object of comparing these with other corporate governance Codes listed above.
1. "The Board of Directors is appointed by the Government of Pakistan as per the provisions of the Banks (Nationalisation) Act 1974. At present all directors (except the President/CEO, who is also the Chairman of the Board) are independent directors", and
2. "Another director has been inducted on the Board representing private shareholders in accordance with section 178(1) of the Companies Ordinance" and that
3. "Three independent directors are included in the Audit Committee of the Board."
The above three disclosures relating to "independence of directors" are very vague and mean nothing to a prospective investor. It has not been explained by the Board, how the independence of the directors has been perceived by the Board in each case, except that they were appointed by the government and they were "non-executive directors".
What criteria have been used to determine their "independence status" has not been made public. If the directors are nominated by the government from outside, it should not automatically be perceived as "independent directors". The Board must explain how they will be able to exercise "independent business judgement" without being subservient to any apparent form of interference from the authority appointing them.
To support this contention, there are examples, where the entire group of nominated directors was removed from the Board through administrative orders without any compliance of the Companies Ordinance 1984. In one case, the Chairman of a Stock Exchange was removed because; he was trying to follow his "independent business decision."
Likewise, the directors of Pakistan State Oil, Pakistan Airlines and Oil and Gas Development Company were removed without following statutory procedures. The entire nomination process seems to be seriously flawed.
These acts reinforce the view that "non-executive directors" should not be regarded as "independent directors", because they are under the influence of the appointing authorities. The Board of the said Bank in this case, seems to have mixed up the status of the "independence of directors" with that of "non-executive directors".
That seems to be the basic reason why "independent directors" are not appointed in the companies controlled by the government. The twenty other compliance statements are not relevant for our purposes, therefore, we do not intend to discuss these except that it has been argued strongly, that these statements should not form part of the Code instead, Boards should provide compliance to SECP through an Annual Return.
The current Code should be reviewed in the light of latest international developments. There should be a clear definition of an "independent director" and "non-executive directors" in the Code of Corporate Governance. How a Board should perceive them to be "independent" in the absence of an established system for consultation, or any access to the specialised agencies for provision of experienced resources to perform the duties of "independent director" remains confusing?
Due attention should be paid that the Code should be enforced in its letter and spirit by both private and public sector companies. The desired amendment should be made to ensure that the Board determines who is an "independent director" and should disclose the basis of this determination.
The recently established Institute of Corporate Governance in Pakistan, various professional bodies and prestigious recruitment agencies should be brought in to play an active and vital role in screening the candidates that are available in the market to fill in the positions of "independent directors" for both public as well as private sectors. They can be truly "independent" in their character and judgement compared with persons appointed on the basis of random picking from friends and personal relations.
As Pakistan is in competition with other countries globally and especially in the Asian continent for attracting investment and is in the process of privatisation of its important companies, these would not attract fair value, if there are lapses in its corporate governance structure.
If we look at the current valuation of a large private sector bank and compare it with the leading government owned bank, the difference between the valuations is quite visible. There seems to be no doubt that matters relating to corporate governance issues also matters among other things.
We should review our Listing Rules relating to compliance in the area of "independence of directors" and should improve to make it a comparable Code that should at least provide a sense of satisfaction to the prospective investors to restore their confidence in the capital markets of Pakistan.
(Concluded)