Journal on Governance, Vol. 1 No. 6, 2012 ‘SKIN IN … journal/contents-4.pdf · Journal on Governance, Vol. 1 No. 6, ... managerial remuneration are not only limited to strict

Journal on Governance, Vol. 1 No. 6, 2012

‘SKIN IN THE GAME’: A CASE FOR

INCENTIVISING INDEPENDENT DIRECTORS

Nithya Narayanan and Manali Gogate

Managerial remuneration in companies has been a subject of wide academic interest and has been discussed and debated upon, not only in India but across jurisdictions. The determinants of optimum managerial remuneration are not only limited to strict legal or commercial issues, but spread to inherent notions of ‘self-interest’. In this paper, we have narrowed down the analysis on managerial remuneration and have specifically focused on issues relating to the remuneration of ‘independent directors’. The paper describes the present corporate governance regime in India and analyses if the compensation for independent directors envisaged under the extant law is effective. In light of the Companies Bill, 2012, we argue that exclusive cash compensation for independent directors would deter, rather than motivate them in performance of their functions of a watchdog, as envisaged thereunder. We advocate that an independent director’s ability to act objectively and independently from management and the company’s performance are directly proportional to the remuneration offered to him. We contend how an independent director’s self-interest is the key factor driving him in efficient execution of his functions. We have discussed in depth the remunerative instruments that give independent directors a skin in the game and thus act as an incentive for them to monitor and administer the activities of the management. We examine the various practices adopted in other countries for compensating

Associate, AZB & Partners, Mumbai. Email: [email protected]. Associate, Juris Corp, Mumbai. Email: [email protected].

The authors wish to thank Mr. Mandar Kagade for his invaluable suggestions and assistance on the paper.

2012] ‘Skin In The Game’: A Case For Incentivising Independent Directors 696

outside independent directors on board of companies and draw attention to the possible pitfalls that can be avoided. We propose a payoff schedule which is a combination of cash compensation and alternative instruments like stock options, restricted stock and the like, for achieving an ideal remuneration structure for independent directors and bringing about effective corporate governance.

Journal on Governance [Vol 1:697 697

CONTENTS

I. Introduction

II. Prevailing Law: Whether Effective?

III. SelfInterest: The Underlying Principle of Effective Corporate Governance

IV. What is ‘Skin in the Game’?

V. Grant of Stock Options An Effectual Remedy?

VI. OptionHitches and Possible Alternatives

VII. Our Proposal

A. Grant of Stock Options

B. Stock Ownership

C. Cash Compensation

VIII. Conclusion

I. Introduction

The invisible hand of selfinterest motivates the proliferation of business.1

It is the basic tenet of corporate law that a company is a separate

legal entity distinct from its shareholders. The major constituents of a company are its members and directors. Directors are agents of shareholders. Monitoring by the board of directors is a key mechanism used to reduce the resulting managerial agency costs. Hence, in the real sense though the shareholders are the owners of a company; the directors act as their agents in the governing and decisionmaking of its corporate affairs. To ensure that directors provide disinterested oversight of management on behalf of shareholders, their independence 1 ADAM SMITH in AN INQUIRY INTO THE NATURE AND CAUSES OF THE WEALTH OF

NATIONS (1776), ¶ IV.2.9 has put forth that each individual strives to become wealthy and simply intends his own gain; and while pursuing the same, individuals usually benefit the society at large more effectively.


from the management is sine qua non for the company's commitment to good governance.

The institution of independent directors and the design of rules governing their independence have long been a subject of intense academic debate. Corporate governance fiascos at Enron, WorldCom and at Satyam Computer Services Ltd. brought this issue under immense scrutiny and have demonstrated that even highly credible, qualified and educated people may not be able to exercise efficient corporate governance oversight. 2 Corporate governance and board independence are important for companies in India which have a concentrated ownership structure and where the laws are not well developed in respect of protection of interests of the minority shareholders. Hence, the role of an independent director as a ‘watchdog’ becomes crucial, for he is required to promote investor protection through integrity and accountability and to act as a bulwark against any opportunistic indiscretions that could be committed by the promoters and the management. It is pertinent to note that this agentprincipal relationship forms the fulcrum of effective corporate governance. In order to serve as the shareholders’ legal fiduciaries and expend independent time and effort in their roles, it is essential that they are adequately compensated for their activities.

Currently, the concept of ‘independent director’3 is recognised

2 Legislatures and exchanges have instigated similar principles regarding

independence all over the world. The SarbanesOxley Act in 2002 and NYSE Listed Company Manual, both required boards to have a majority of independent directors. Likewise, the OECD Principles of Corporate Governance state that boards should assign a specific number of nonexecutive directors that are able to exercise independent judgment surrounding issues where there is a potential conflict of interest.

3 Clause 49 defines an independent director as a nonexecutive director who, inter alia, (a) apart from receiving director’s remuneration, does not have any material pecuniary relationships or transactions with the company, its promoters, its senior management or its holding company; (b) is not related to the promoters or management at the board level or at one level below the board; (c) has not been an executive of the company in the immediately preceding three financial years; (d) is not a partner or executive of the statutory audit firm or the internal audit firm that is associated with the company, and has not been a partner or executive of any such firm for the last three years. This will also apply to legal firms and consulting firms that have material association with the entity; (e) is not a supplier, service provider


and governed by Clause 49 of the Listing Agreement4 (Clause 49) and under the Companies Act, 19565 (Companies Act). Indian law does not have any specific provision regarding the duties and obligations of an independent director. Company boards normally have a mixture of executive, nonexecutive, and independent directors. The traditional difference between independent directors and the rest of the board is their ability to act objectively and independently from management.

In this paper, we advocate that independent directors’ ability to act objectively and independently from management and the company’s performance are closely related to the remuneration offered to them. We argue that exclusive cash compensation for an independent director, as proposed under the Companies Bill 2012 (Bill), would deter rather than motivate him to function as a watchdog he is envisaged to be. The paper is divided as follows: Section II describes the present corporate governance regime in India and analyses if the compensation for independent directors envisaged under the extant law is effective. Section III explores how directors are driven by the primeval norm of self-interest for efficient execution of their functions. Sections IV and V discuss the remunerative instruments that give independent directors a skin in the game by aligning their interests with that of the shareholders, thereby incentivising them to effectually govern the corporate. We argue that in addition to cash compensation, stock options and restricted stock should be granted to independent directors. Section VI examines the possible glitches posed by these alternative remunerative instruments and proposes certain measures to overcome the same. Section VII discusses our proposal in respect of achieving an ideal remuneration structure for independent directors. Section VIII concludes.

or customer of the company. This should include lessorlessee type of relations also and (f) does not own two per cent or more of voting shares.

4 The Listing Agreement, a subordinate legislation drawing sanction from the Securities Contracts (Regulation) Act, 1956, governs conditions for listing the shares of companies and continuing requirements that need to be complied with by companies whose shares are listed on any recognised stock exchange in India.

5 As the Companies Act, 1956 does not make a specific reference to the term ‘independent director’, it would fall within the ambit of a ‘nonexecutive director’ under it.


I. Prevailing Law: Whether Effective?

Though directors are supposed to safeguard and promote shareholders’ interests, this is observed to be more of a fiction than reality. It is necessary to incentivise the independent directors and align their interests with the shareholders so that they safeguard the interests of the latter, to whom they are accountable. 6 Currently in India, independent directors are paid a mix of sitting fees, stock options, stock units and commission and they all come with prescribed ceilings. Under Clause 49, all fees/compensation for independent directors are required to be fixed by the board of directors of the company and requires previous approval of the shareholders, who are required to specify the limits for the maximum number of stock options that can be granted to independent directors, in any financial year and in aggregate. This prior approval is not applicable if the fees are within the limits set out under the Companies Act,7 which states that the remuneration paid to such director or all such directors together who are neither in the wholetime employment of the company nor a managing director, cannot exceed one per cent of the net profits of the company, if the company has a managing or wholetime director or a manager, or three per cent of its net profits, in any other case. An independent director may be paid remuneration exceeding such limits, with the approval of the Central Government, by way of a resolution in a general meeting.

The Bill, however, has proposed to do away with stock options that can be given to independent directors and restrict their compensation only to sitting fees, reimbursement of expenses for participating in meetings of the company and profit related commission as may be approved by the members of the company. This draconian stance has been further exacerbated by the proposal to cap such cash compensation by the Central Government at a future date.8

6 Krista Angela M. Montealegre, SEC Allows Independent Directors To Take Part In

Stock Option Plans (2012) InterAksyon.com, available at http://www.interaksyon. com/business/37416/secallowsindependentdirectorstotakepartinstockoptionplans.

7 Clause 49(I)(B), the Listing Agreement, read with § 309(4) the Companies Act, 1956.

8 Clause 197 and 200, the Companies Bill, 2012.


By equating mere outside status, characterised by absence of any pecuniary relationship, irrespective of whether or not such relationship is ‘material’,9 a cap on his holding in the company and a ban on the grant of stock options, the Bill may induce disinterested and passive behaviour on the part of independent directors in the board room and makes apparent pathologies of going overboard with the notion of independence. This would only generate nominally interested directors who would simply rubberstamp every proposal of the board, for their personal interest is so decoupled from the company, that they have no incentive to actively participate and channel policies of the company.10 In other words, for a director to truly perform the role of a conscience keeper, he needs to have the ‘skin in the game’, in conjunction with cash compensation, thereby having interests symmetrical to the shareholders’.11 II. Self-Interest: The Underlying Principle of Effective Corporate

Governance

Maximising selfinterest has always been the underpinning motive of all human behaviour. This means that each person has but one ultimate aim: his own welfare.12 Though traditionally, executive and nonexecutive directors have different motivations, Indian law does not specifically differentiate between their duties and liabilities.

An independent director is an outsider appointed on board of the company, having little or no interest in the company, hence is not 9 While Clause 49 of the Listing Agreement sets out a disqualification for an

independent director in the event of any ‘material pecuniary relationship’ held with the company, the Companies Bill, 2012 has dropped the term ‘material’. This would presumably narrow the purview of the definition of an independent director even further.

10 Cf. Mandar Kagade, Independent Director Law In India: An Economic And Behavioral Analysis, 1 INDIAN JOURNAL OF LAW AND ECONOMICS, 116. (2010).

11 Byard, Donal A. and Li, Ying, The Impact of Directors' Option Compensation on Their Independence (February 2005), available at http://cicfconference.net /cicf2006/cicf2006paper/20060201123102.pdf, http://w4.stern.nyu.edu/accounting/docs/speaker_papers/fall2004/Byard_Oct8.pdf.

12 Shaver, Robert, Egoism, THE STANFORD ENCYCLOPEDIA OF PHILOSOPHY (Winter 2010 Edition), Edward N. Zalta (ed.), available at http://plato.stanford.edu/ archives/win2010/entries/egoism.


motivated to monitor its management. There is evidence that independent directors appointed to serve on the board of wellknown and well respected Indian companies do not attend board meetings; thereby defeating the primary objective sought to be achieved by their appointment, which is causing much criticism about India’s absentee independent directors. 13 In our opinion, reputational enhancement and economic interest in the enterprise are the driving forces for independent directors. In this paper we concentrate on how appropriate economic incentives act as a powerful personal enticement for the independent directors to exercise effective oversight.

As discussed in the preceding Section, the Bill provides for exclusive cash compensation subject to prospective caps. Moreover, the Bill restricts the holding of independent directors (along with holding of any relative of such independent directors) to less than two percent of the total voting power of the company.14 This view of the legislature assumes that true independence in the boardroom is achievable only by decoupling the directors’ economic interests in the company from their primary responsibility of engaging in active management oversight. The independence of directors, although important, is required to be maintained vis-à-vis the executive directors and substantial shareholders and not vis-à-vis other shareholders. Independent directors are appointed for the task of protecting shareholder interests; hence it is alignment with and not independence from shareholders that is warranted.15

Equity ownership can create an effective agency. As stated

before, people will always act in a way to maximise their own self

13 India Inc's Absentee Independent Directors, The Firm, CNBC NETWORK 18,

September 15, 2011, available at http://thefirm.moneycontrol.com/story_page.php ?autono=758187.

14 Clause 149(6)(d), the Companies Bill, 2012. 15 The NYSE has taken a much more sensible approach to classifying independent

directors than the Companies Bill, 2012. Deeming that a nonexecutive director is not independent if they have a material relationship with the company, the exchange also states, “as the concern is independence from management, the Exchange does not view ownership of even a significant amount of stock, by itself, as a bar to an independence finding.” Likewise, NASDAQ does not see share ownership as a barrier to independence, unless the director sits on the audit committee.


interest. When the two interests are aligned, independent directors acting in their own interests will inadvertently also maximise the interests of the shareholders and would be more motivated to endorse valueadding strategies. Independent directors should thus have a ‘skin in the game’, so that they are not mere passive observers, but active fiduciaries.16

III. What is ‘Skin in the Game’?

The idea behind creating a ‘skin in the game’17 situation is to

ensure that likeminded individuals who share a stake in the company have a greater incentive to manage and govern the company. It refers to a situation in which an executive in a publicly traded company uses his/her own money to buy stock in that company, thereby aligning his interests with those of the shareholders. Investment of their capital into the company by independent directors is a sign of good faith or a show of confidence in the future of the company. Clause 149(9) of the Bill clearly states that an independent director cannot receive remuneration by means of a stock option.

However, we believe an agency with a substantial portion of its compensation at risk would be more effective than an agency with nothing at risk. Thus, independent directors have to be incentivised by blending cash compensation with other noncash remunerative instruments like stock, restricted stock, stock options, warrants and the like. This can mitigate agency problems between directors and shareholders. In the next section we analyse whether stock options are an effective form of remuneration for independent directors. We also take into account the interest asymmetry that stock options create which makes other alternative remunerative instruments like restricted stock more attractive.

16 Why Yahoo and other Outside Directors Should Have Skin In the Game, December

2, 2006, available at http://breakoutperformance.blogspot.in/2006/12/whyoutsidedirectorsshouldhaveskin.html.

17 ‘Skin in the Game’ is a term coined by renowned investor Warren Buffett. It refers to a situation in which an executive in a publicly traded company uses his/her own money to buy stock in that company, available at www.investopedia.com /terms/s/skininthegame.com.


IV. Grant of Stock Options- An Effectual Remedy?

As discussed in Section IV, the trend to put directors in the same position as shareholders can only bring about a positive change for the companies they manage. A stock option gives employees and directors the right to buy a certain number of shares of the employer's (or company’s) stock at a stated price. A shareholder would ideally want to say that ‘we care about the stock price, and we want you to care about the stock price’.18 The Securities and Exchange Board of India (Employee Stock Option Scheme and Employee Stock Purchase Scheme) Guidelines, 199919 (Guidelines) permit independent directors to be issued stock options. An ‘option grantee’ under the Guidelines means an employee having right but not an obligation to exercise in pursuance of the employee stock option scheme (ESOS). The only restriction that the Guidelines impose is that a director who directly or indirectly holds more than ten per cent of the outstanding equity shares of the company would not be eligible to participate in the employee stock option scheme.20 This would further be subject to the cap prescribed under Clause 49.21 There is substantial evidence in legal literature that a company’s performance is closely related to the stock ownership of its independent directors. 22 Linking the compensation of such directors to performance

18 Beth Silver, More Firms Put Directors In Shareholders’ Shoes, August 1994,

available at http://www.personnelsystems.com/dir_comp.htm. 19 These guidelines are issued by the Securities and Exchange Board of India under

the Securities and Exchange Board of India Act, 1992, in respect of regulation of stock option schemes granted by public listed companies.

20 Clause 4.3, Securities and Exchange Board of India (Employee Stock Option Scheme and Employee Stock Purchase Scheme), Guidelines 1999.

21 As per Clause 49 of the Listing Agreement, an independent director is not permitted to hold two per cent or more of the block of voting shares of the company.

22 Sanjai Bhagat and Heather Tookes, Voluntary And Mandatory Skin In The Game: Understanding Outside Directors’ Stock Holdings, 2011, THE EUROPEAN

JOURNAL OF FINANCE, available at http://dx.doi.org/10.1080/1351847X.2011. 579739; see, Report by the AsiaPacific Office of the CFA Institute Centre for Financial Market Integrity, Independent Non-Executive Directors: A Search for True Independence in Asia.


of a company's stock gives such directors an air of accountability. They have also evolved into becoming a major element of nonsalary based compensation as a means of attracting and retaining eminent individuals, especially for startups and cash strapped companies with limited cash flows. 23 Based on our indepth study on the practices adopted by the legislatures across the globe, we understand that the USA, UK, Canada, Australia, Singapore, Hong Kong, Philippines, to name a few, do not expressly prohibit stock options for independent directors.24

V. Option-Hitches And Possible Alternatives On the other side of the coin, in certain situations, awarding stock options to directors may have certain pitfalls. The nature of stock options is peculiar, for these instruments are not completely symmetrical to shareholder interests. Stock options are typically awarded at no cost, with the expectation that when stock price increases, it will benefit both the directors and shareholders. However, when the stock price declines, the shareholders would suffer a loss in their investment; however, the directors as holders of the stock options do not experience any outofpocket loss. Thus, there is no commercial downside for directors with stock options; in other words, the directors and shareholders win together, but don’t lose together. This convex payoff schedule25 and lack of total symmetry with the shareholders induce greater risktaking on part of directors, which may not necessarily be in the best interests of the shareholders.26 23 Huldah A. Ryan et al, Fraud Versus Ethics: The Case of the Backdating of Stock

Options, 6, JOURNAL OF BUSINESS AND ECONOMICS RESEARCH (April 2008). 24 Report by KPMG and the Associated Chambers of Commerce and Industry of

India, Role of Independent Directors-Issues and Challenges, available at www.kpmg.com/IN/en/.../Role_of_Independent_Directors.pdf.

25‘ Convex Payoff Function’ means a return function that has higher returns at the extreme values of the underlying asset, and lower returns at values close to the average value of the underlying asset, available at http://www.amex.com /servlet/AmexFnDictionary?pageid=display&word=Convex%20Payoff%20Function.

26 Shamsud D. Chowdhury, Director Compensation: The Growing Popularity of Deferred Stock Units, IVEY BUSINESS JOURNAL (January/February 2009), available at http://www.iveybusinessjournal.com/topics/leadership/directorcompensationth egrowingpopularityofdeferredstockunits.


Also, stock options have been criticised for bringing only shortterm benefits, as independent directors take decisions only on the basis of shortterm returns that are likely to accrue to them with the performance of the company. In order to realise their monetary value immediately, such directors forgo the time value of these options and exercise them early, thereby compromising upon the interests of the longterm equity holders of the company.

The aftermath of grave accounting frauds in reputed companies and the recent aversion to options exercised by directors by some, suggests that stock options could also lead to agency problems, such as backdating.27 Directors with more wealth tied up in stock options may pursue activities that lead to personal gain, such as option backdating, which potentially increases the option of recipient’s compensation.28 This issue has prompted discussions amongst securities’ regulators to devise the best modus of compensating outside directors and keep them focused on shareholder interests, while protecting their independence. However, backdating of options is not an issue that is faced in India, primarily because the Guidelines require the shareholders of the company to approve the employee stock option scheme by passing a special resolution in a general meeting. They also require the company to file a statement of disclosure on the scheme with the stock exchanges on which its shares are listed, before the exercise of the option, to obtain an inprinciple approval from such stock exchange.29 Also, as and when the stock options are exercised, the company is also required to notify the same to the stock exchanges. 30 Hence, the stringent statutory framework in India reduces the likelihood of such stock option related scams.

27 In general, stock options are granted ‘atthemoney’ (i.e., where the exercise price

equals the market price of the stock on the grant date). Backdating helps the recipients of the options to obtain inthemoney options, thus enhancing the value of their option grants.

28 Backdating is not per se illegal. However, this phenomenon raises concerns about the effectiveness of corporate governance in setting executive pay. We have not dealt with the issues that stem out of backdating of stock options, as the same is beyond the scope of this paper.

29 Clause 22.1 (b), Securities and Exchange Board of India (Employee Stock Option Scheme and Employee Stock Purchase Scheme), Guidelines 1999.

30 Clause 22.1 (c), Securities and Exchange Board of India (Employee Stock Option Scheme and Employee Stock Purchase Scheme), Guidelines 1999.


Apart from stock options, there exist other alternative remunerative instruments that can be awarded to independent directors in order to meet the twin objectives of payforperformance and interest alignment. Granting of restricted stock31 is considered to be a better mode of compensation. A restricted stock plan is a stock option plan under which the transferred stock option is subject to restrictions regarding transferability and to substantial risk of forfeiture. Unlike stock options, where the recipient has the option to buy stock, in case of restricted stock, the director has already purchased the stock, however the vesting of the same is deferred. The vesting requirement for such restricted stock may be either timebased (a stated period from the grant date) or performancebased (financial and/or nonfinancial measures of individual or company performance). Hence, they are categorised as longterm incentives and preferred over options.32 In case of restricted stock, the director is required to take the financial risk in buying the stock of the company, unlike an option, where there is no obligation to buy the stock. Moreover, restricted stock results in change of director and shareholder wealth in the same direction (in total symmetry, unlike stock options); in other words, the directors and shareholders win together and lose together. The grant of deferred stock in order to align the interests of nonexecutive, or outside directors with those of the stockholders has gained popularity in the USA33 and Canada.34

However, the Bill categorically states that a director is said to

be independent only if he, himself or together with his relatives does not hold two percent or more of the total voting rights of the company. 35 Even Clause 49 has a similar provision that inter alia 31 Restricted stock, by definition, means a stock with restrictions on voting rights,

transferability and right to dividend. Restricted stock units as implemented in India are nothing but deep discounted employee stock option plans, available at http://www.thehindubusinessline.in/iw/2011/01/23/stories/2011012350390500.htm

32 Supra note 27. 33 CocaCola in the year 2006 unveiled a plan to pay directors solely through

annually allocated restricted stock units on the conditions that they cannot be cashed until three years have passed and only upon the company making an annual growth of eight per cent in earnings per share, available at http://breakoutperformance. blogspot.in/2006/12/ibmendsdirectorstockoptionsas.html.

34 Supra note 27. 35 Clause 149(6)(d), Companies Bill, 2012.


defines independent director as a nonexecutive director who is not a substantial shareholder of the company, i.e. not owning two per cent or more of the block of voting shares. This essentially means that independent directors cannot hold more than two per cent of the voting stock of the company either by way of shares, restricted stock units or stock options. This position is not on the same lines as the Guidelines discussed in Section IV, which do not impose any such cap on grant of stock options to directors.

In Australia, for example, the Australian Security Exchange listing rules state that the director ceases to be ‘independent’ if he holds five per cent or more stock ownership.36 However, as per the New York Stock Exchange and NASDAQ listing rules, stock ownership is not a barrier to independence. Singapore has a governance code that is silent on substantial shareholders in its guidelines on independence. For the purpose of determining independence, a holding of two per cent of voting shares is considered substantial in Philippines, whereas in Hong Kong, the defining level is an interest of five per cent or more.37 In the event that complete absence of any caps on the holding of an independent director in a company is not a tenable position, we urge the regulators to consider raising the cap, perhaps up to five per cent at the very least. This would lean towards greater alignment of the interests of the independent directors and shareholders.

VI. Our Proposal

Based on the analysis of the present law and the provisions of the Bill, we present the following proposals as alternatives to the provisions relating to the remuneration of independent directors.

The complexity of the role played by the independent director and his responsibilities, opportunity cost, the actual time spent in 36 ASX Principles of Good Corporate Governance and Best Practice

Recommendations (2003) discourage the issuance of share options as part of the remuneration of nonexecutive directors, See, ASX Corporate Governance Council, Principles of good corporate governance and best practice recommendations, (2003).

37 See, India’s Listing Agreement, Clause 49; Rule 38, Philippines’ Amended Implementing Rules and Regulations of the Securities Regulation Code and Rule 3.13(1), Honk Kong’s HKEx Main Board Listing Rules.


fulfilling duties owed to the company and his relevant experience, are all factors that drive remuneration for independent directors. A major proportion of independent director’s compensation should be fixed, based on the assigned responsibilities and time commitment, with the variable component linked to meeting attendance, contribution in board meetings, ability to stay abreast of industry and company developments and performance as measured by objective board evaluations. As recommended in the UK Corporate Governance Code38, we are of the view that levels of remuneration for nonexecutive independent directors should reflect the commitment in terms of time and responsibilities of the role of the independent director. Also, at the time of their appointment, independent directors could also give an undertaking that they would have sufficient time to meet what is expected of them.39 We also suggest that a significant proportion of executive directors’ remuneration should be structured so as to link rewards to corporate and individual performance.

A onesizefitsall approach adopted by the legislature, by laying down inflexible straightjacket caps on the director remuneration is not the appropriate means to ensure corporate governance. Measures undertaken for good governance will, and in practice certainly do, differ from company to company, depending on factors such as size, ownership structure, and the nature of individual business activities. We acknowledge the fact that it would not be practical and cost efficient to have a regulation tailored to cater to different needs of diverse companies and hence suggest that companies should be allowed to a degree of flexibility in their choice of corporate governance processes.

Moreover, as shareholders are the true owners of the company,

their say on pay,40 on the quantum of remuneration for their directors

38 The UK Corporate Governance Code sets forth standards of good practice with

respect to board leadership and effectiveness, remuneration, accountability and shareholder relations. Listed companies in the UK are required under the Listing Rules to report on how they have complied with the Code in their annual report and accounts.

39 Derek Higgs, Review Of The Role And Effectiveness Of Non-Executive Directors, January 2003), available at http://www.ecgi.org/codes/documents/higgsreport.pdf.

40 § 951, the Dodd Frank Act, 2010, requires companies to approach shareholders for their nonbinding vote on executive compensation and golden parachutes. Even


should outweigh any regulatory limits imposed thereupon. Not only do the present and the proposed law impose stringent caps on remuneration, the proposed law goes a step further to reduce the compensation payable to independent director to nothing more than capped cash compensation. We believe that imposing any upper limit on the remuneration payable to independent directors would result in micromanagement by the legislature. Regulation by the Government of the quantum of sitting fees is such a manner could tend to be counterproductive in the longer term. In an age where the concept of ‘corporate autonomy’ is being strengthened, and in a country that is speedily opening up to global investment, overregulation should be best avoided. In the subsequent paragraphs, we propose suitable alternatives, conceived in light of these factors.

A. Grant of Stock Options

We acknowledge that granting of stock options would not only

align the director’s interest with that of the shareholder, but would also act as a coercive device for him to take steps in the direction of stock price augmentation. However, based on possible pitfalls that we have discoursed in Section VI of the paper, we believe that stock options offer a cushioned investment to such director; an option which he could exercise only when the profitability of exercising it is at the optimum. Thus, stock options work as a running guarantee for the monetary risk undertaken by the director, as a result of which he could take on ventures that might not necessarily be for the welfare of the shareholders.

Although the UK Corporate Governance Code suggests preclusion of share options or other performancerelated elements, it recommends a prior approval of the shareholders to be sought, if stock options are to be granted and requires the shares acquired by exercise of the options to be held for a period of at least a year. Taking cue from the concerns flagged by regulators globally and the growing popularity of stock options, it may be more relevant to place restrictions either on

UK’s say on pay vote is currently limited to a shareholder advisory vote on the compensation of directors. Recently, in June 2012, the UK Secretary of State has proposed a binding shareholder vote on the company’s policy regarding compensation of directors.


the total amount of options or on the manner in which these options are exercised, instead of completely prohibiting stock options.

A safeguard that a company could adopt would be having a holding requirement that vetoes a board member from selling his stock for a specified period. Stock options could vest in the directors at distinct intervals during their tenure or be exercisable, upon certain predecided terms and conditions, as per a specified time or performancebased schedule. This would also ensure that retiring directors, who would not be continuing for another successive term, would continue to hold an interest till the end of their tenure. A staggered vesting of the options could also be structured such that the vesting takes place at a certain period of time after the director leaves the company. 41 Alternatively, directors could be required to purchase meaningful amounts of stock themselves (not through grants) and then be paid in cash.

B. Stock Ownership

Ownership of company stock is an essential manner of ensuring

that directors share the interests of shareholders. Hence, to fully ensure director independence, directors should have a significant stake in the business. This calls for directors to be compensated by having 'lockedin' shares in addition to cash compensation. It could be a viable proposal to mandate that the stocks held by the independent directors in the company, to be so held for a certain period of time after the expiry of his term as an independent director. This would mitigate risks in relation to insider trading.42 However, given the symmetry in payoffs, the director would be exposed to a downside risk and loss should the stock price depreciate. This is likely to reduce the supply pool of willing directors wanting to act as independent directors.

41 See, Executive Summary of the Naresh Chandra Committee Report, available at

http://finmin.nic.in/reports/chandra.pdf . 42 See, Report of the CII Task Force on Corporate Governance (November 2009),

available at http://www.mca.gov.in/Ministry/latestnews/Draft_Report_Naresh Chandra _CII.pdf.


C. Cash Compensation A dilemma widely debated upon in respect of independent directors, is that quantum of remuneration when too high, may compromise his independence, and when too low, jeopardise the chances of finding a person willing to be appointed as an independent director. They should be paid adequate sitting fees based on the twin criteria of net worth and turnover of companies. Moreover, there have been proposals put forth in India advocating a remuneration structure for independent directors, having a fixed component of remuneration and a variable component that is linked to the profit or any other variable in relation to the performance of the company. 43 Timebased and performancebased bonuses could be given to such directors, which could be immediate or deferred. An argument against linking independent director remuneration with profits of the company would be that the shareholders of a company do not necessarily receive dividend only in case of profits made by the company; dividends can also be paid from free reserves of the company. In such a case, it would be unfair to maintain that independent director remuneration to be only taken from or represent a part of the profits of the company. A suggestion in order to cure this obstacle would perhaps lie in fixing the contractual remuneration, much like the fixed remuneration enjoyed by wholetime directors of a company. The independent director can choose between a fixed contractual remuneration or profit based commissions as available currently under the law, as a precaution to avoid situations of dual benefits accruing to him.44

A review of the practices adopted in major jurisdictions shows that there is no standard recompense schedule that is followed for independent directors, for their contributions in company, primarily because such standards are impossible to set and are subject to numerous variances that exist within a company as well as in the industry. An appraisal of the remuneration structure in the USA and Europe indicates that the practice in Europe varies vastly; countries such as Sweden, Denmark and Switzerland have over 95 per cent of the

43 See, Voluntary Guidelines on Corporate Governance, (2009), available at

http://www.mca.gov.in/Ministry/latestnews/CG_Voluntary_Guidelines_2009_24dec2009.pdf.

44 Id.


total remuneration as fixed fees, whereas countries such as France and Germany have less than 60 per cent of the total remuneration as fixed.45 Some European companies include other layers of fees, including, attendance fees, variable fees based on company performance, basic fees for committee membership and chairmanship and committee attendance fees. 46 However, in the USA, though the Securities Exchange Act, 1934 and the Dodd Frank Act, 2010 do not prescribe for any upper limit for the compensation that can be given to independent directors, the NASDAQ47 and NYSE Listing Rules48 state that one of the conditions for a director to cease being qualified as independent if he has received, during any twelvemonth period within the last three years, more than USD 120,000 as direct compensation from the company, other than director and committee fees, pension or other forms of deferred compensation for prior service, where such compensation is not contingent in any way on continued service.

Moreover, as per the amended service tax regime49 in India, with effect from 1 July 2012, the Ministry of Finance has sought to make the remuneration, sitting fees etc. paid to independent directors amenable to service tax. Not only does this mean that independent directors will be required to register themselves with the government as required by rules governing service tax, but it will also additionally bring them under the scanner of the government. With an already narrow definition of independent directors, additional registration and regulatory scrutiny may make it further difficult for Indian corporates to identify persons who are willing to be appointed as independent directors. Although it is debatable whether skyhigh compensation takes away the ‘independence’ of an outside director, in India, in light of the above, issues of practical feasibility may arguably dictate a higher compensation payable to independent directors.

45 Supra note 25 46 Maja LeviJakšić and Slađana Barjaktarović Rakočević, Innovative management &

business performance: [symposium proceedings] (University of Belgrade, Faculty of Organizational Sciences, 2012), 1416.

47 Listing Rule 5605(a)(2)(B). 48 Listing Rule 303A.02(b)(ii). 49 The 2012 Budget has introduced a negative list in relation to the services amenable

to service tax.


VII. Conclusion

Exclusive and capped cash compensation along with the barriers to equity ownership in the company may provide for little incentive for independent directors to exert the effort and seek and endorse strategies that add value to a company.50 As per the publicly available data, corporate India currently has approximately 20,000 independent directors and needs to fill in 30,000 more. 51 In basic economics parlance, a lower supply and an increasing demand will dictate higher compensation payable. However, this read in light of the current and proposed law would result in a class of dissatisfied and underpaid independent directors and a position least favouring corporate governance and shareholders’ interests.

Recently, the Securities Exchange Board of India (SEBI) chairman, Mr UK Sinha, made a statement that the regulator was planning to regulate executive and nonexecutive compensation in listed companies. 52 We believe such a move would only result in nothing but overregulation. The extant law under Clause 49 and the Bill covers it comprehensively. However, we are of the opinion that the provisions of the Bill, those specifically dealing with the compensation structure for independent directors, as currently proposed, is far from achieving the transparency and accountability in corporate governance, as envisaged there under. We do not find any reasonable justification for exclusive cash compensation for independent directors, and a blanket ban on them owning stock options in the company. Moreover, we find the two per cent cap on ownership of voting stock arbitrary and unjustified. The measures adopted by the legislature to ensure that the independent directors are truly independent seem unsupported and irrational. They pose as impediments rather than catalysts in ensuring a corruptfree corporate environment. To quote Mr Pratip Kar, former executive director of SEBI, ‘Companies cannot expect to pay peanuts

50 Even, the Voluntary Guidelines on Corporate Governance, 2009, acknowledge the

fact that it is essential to attract, retain and motivate independent directors. 51 Indian Directors May Have to Pay Service Tax Soon, available at

businessworld.in:8080/en/storypage//bw/independentdirectorsmayhavetopayservicetaxsoon/445110.0/page/0.

52 See, http://www.business-standard.com/india/news/sebi-may-crack-downcorpo-rate-executive-pay/486148.


and get eminent people to take time out and bring their expertise, experience and independent judgement.’53 After all, there ain't no such thing as a free lunch!

53 Vivek Sinha, Independent Directors' Fee Match Salaries Paid To CEOs, available

at http://articles.economictimes.indiatimes.com/20110103/news/28425210_1_ind ependent directors amanmehtaboardseat.

Documents

Journal on Governance, Vol. 1 No. 6, 2012 ‘SKIN IN … journal/contents-4.pdf · Journal on Governance, Vol. 1 No. 6, ... managerial remuneration are not only limited to strict