Should You Include Independent Directors in Your Forensic Analysis of a Stock?

Numerous studies conducted by prestigious universities over the years reveal a robust correlation between effective corporate governance and enhanced corporate financial performance.

Recent research conducted by renowned institutions like Harvard and the University of Pennsylvania emphasises that companies with robust shareholder rights protections outperform those with weaker safeguards by 10-12% each year.

This explains why investors gravitate towards companies renowned for their respectable corporate governance standards.

Given the Indian market's pursuit of heightened foreign investor participation in the market, it is important to prioritise the promotion of best corporate governance practices among the listed firms.

The cornerstone of sound corporate governance rests heavily on the efficacy and competence of independent directors.

Independent directors are individuals appointed to the board of directors of a publicly listed company. They are referred to as 'independent' because they do not have any material financial connection or interest with the company or its management.

Their role is to bring objectivity, impartiality, and a fresh perspective to the board, enhancing corporate governance and oversight.

Generally, they are considered as mentors of management, to ensure that management action creates value for shareholders, largely responsible for protecting minority shareholders' interests.

Independent Directors: A Crucial Safeguard Against Corporate Misconduct

The board of directors, as a whole, is the governing body of a company.

Their members are elected by shareholders (in the case of public companies) to set strategy, oversee management and protect the interests of shareholders and stakeholders.

The board members of a company are not just the face of a company. They carry the authority to question the management and protect minority shareholders.

Back in 2009, when the chairman of Satyam Computers was suspected of falsifying the company's books of accounts over several years, the independent director's responsibility came into question for not identifying the misrepresentation made in the company's books.

Similar concerns emerged during the Ratan Tata-Cyrus Mistry boardroom dispute.

Recently, Infosys, revered for its governance standards, faced regulatory scrutiny, with the market regulator's Chairman highlighting issues like ineffective audit committees and lack of independence among directors.

According to the Companies Act 2015, 50% of the board of directors of Indian companies must be independent.

Having a majority of independent directors enables outside directors to feel supported when voicing alternative viewpoints.

Otherwise, it might be challenging for a lone outside director to raise sensitive issues that could conflict with the interests of the family or founder.

Beyond Compliance: Selecting Competent and Empowered Independent Directors

Companies typically adhere to the independence requirements outlined in the Companies Act and SEBI Regulations.

However, they frequently overlook the competencies and knowledge necessary to fulfil the responsibilities entrusted to directors.

New regulations mandate transparency and thorough explanation in the selection process of independent directors.

The panel responsible for their selection must disclose the specific skills needed for the role and how each candidate aligns with those requirements.

SEBI has outlined that for every independent director appointment, the nomination and remuneration committee must assess the board's overall skills, knowledge, and experience.

Based on this evaluation, a description of the necessary role and capabilities of an independent director should be prepared.

The committee can seek assistance from external agencies to identify suitable candidates, consider diverse backgrounds, and account for time commitments.

Candidates for the Board of Directors can be nominated by the company's nominations committee or by external parties advocating for change.

Diversity and Rotation: Key Ingredients for Effective Boards

The expertise and qualifications that each independent board member brings to the table matter a lot. Therefore it is important to ask important questions like, are they sufficiently qualified to lead the board of a company?

Do they possess pertinent business acumen and experience? Equally significant is their level of engagement and responsibility during board meetings.

These factors determine the effectiveness of a board in guiding the company's strategic direction and ensuring its long-term success.

The best-managed boards, actively promote diversity by ensuring a broad range of skill sets among their members.

While many Indian organisations traditionally lean towards having independent directors with backgrounds in accounting, law, or government, the top-performing boards take a different approach.

They structure their boards according to the specific needs of the business, seeking directors with expertise that aligns with the company's operations.

Take for example Tata Consultancy Services (TCS). Its board boasts several independent directors, each bringing a wealth of experience and impartiality to the table.

TCS - Board Members

Name	Reported Designation
Keki M Mistry	Independent Non-Executive Director
OP Bhatt	Independent Non-Executive Director
N Chandrasekaran	Chairman
Pradeep Manohar Gaitonde	Company Secretary & Compliance Officer
N Ganapathy Subramaniam	Executive Director & Chief Operating Officer
Don Callahan	Independent Non-Executive Director
Hanne Birgitte Breinbjerg Sorensen	Independent Non-Executive Director
Pradeep Kumar Khosla	Independent Non-Executive Director
K Krithivasan	Managing Director & Chief Executive Officer
Aarthi Subramanian	Non Independent & Non Executive Director

Data Source: Ace Equity

Given that BFSI segment of the business commands a lion's share (in form of total revenues), the company has two prominent players from the banking industry presiding as independent directors on their board.

These include Keki Mistry, who played a critical role in the successful transformation of HDFC into India's leading financial services conglomerate and OP Bhatt, the Chairman of State Bank Group, which includes State Bank of India (SBI), India's largest commercial bank.

These directors serve as watchdogs, ensuring that TCS operates ethically and in the best interests of its shareholders.

There is a good chance that the CEO of a company can conceals the true state of affairs from potential investors and stakeholders.

Therefore, an individual well-versed in a similar line of business, devoid of any internal ties to the company's management, would independently act in the interest of its shareholders and stakeholders.

Moreover, well-respectable boards typically feature representation from at least five different professional backgrounds, ensuring a diverse range of perspectives and insights.

What's more, there's a deliberate effort to avoid redundancy, with no two directors sharing the same skill set.

Furthermore, a good set of directors fosters diversity of thought within its board through a structured director rotation process.

This ensures fresh perspectives are continually brought to the table, driving innovation and strategic decision-making.

Demand for Board Members Spikes, Compensation Follows

At present, independent directors are in high demand, with companies offering substantial pay raises to secure their presence on boards.

The demand for independent directors has become more pronounced, with over 2,000 independent directors set to complete their tenures by April 2024.

According to data sourced from primeinfobase.com, a corporate data tracker, the terms of six independent directors at MRF, and five each at Dabur India and GMR Airports Infrastructure, will expire in 2024.

Additionally, firms including Ashok Leyland, Bharat Forge, HCL Technologies, Larsen & Toubro, Phoenix Mills, and Pidilite Industries have four independent directors whose tenures are ending this year.

According to a Deloitte study shared exclusively with Mint, compensation for independent directors of 50 leading stocks has doubled over the past five financial years.

Deloitte's findings reveal that now, four out of every 10 independent directors earn salaries exceeding Rs 10 million (m), a significant increase from just one out of 10 five years ago.

IT firms, in particular, offer higher remuneration to their independent directors due to their higher rate of international hires compared to other sectors.

Compensation for these directors increased from Rs 10.4 m in financial 2018 to Rs 15.2 m in the latest financial year.

The life sciences industry has experienced the most significant spikes in compensation for independent directors.

Average compensation in this sector rose from about Rs 3 m in financial year 2018 to Rs 7 m in the following year, reflecting companies' efforts to retain top talent.

However, independent directors in the financial services sector face limitations on their remuneration, with the Reserve Bank of India capping compensation for non-executive directors at Rs 2 m, including meeting-related fees and expenses.

The diverse compensation trends across sectors highlight the challenges encountered by independent directors, particularly those managing multiple board responsibilities.

Spreading Themselves Thin

The recent case of the independent director of Paytm Payments Bank, Manju Agarwal has brought to light the troubles faced by independent directors juggling multiple board positions.

Manju Agarwal, the former SBI deputy managing director, with her extensive experience and expertise in the banking and finance sectors, was undoubtedly an attractive candidate for various board positions.

However, her recent inability to effectively navigate the challenges at Paytm Payments Bank has cast a shadow over her reputation as a diligent and effective independent director.

As a result, she has resigned from the board of another company, CMS Infosystems.

This scenario highlights the delicate balance independent directors must maintain between fulfilling their duties effectively on multiple boards and avoiding conflicts of interest.

While diverse board experiences can enrich their perspectives and contribute positively to corporate governance, excessive board commitments can potentially dilute their effectiveness and compromise their ability to devote sufficient time and attention to each role.

Thus, boards must ensure that their members have the capacity to fulfil their responsibilities diligently and impartially, thereby safeguarding the interests of shareholders and stakeholders alike.

In conclusion

When it comes to analysing stocks forensically, independent directors are invaluable.

Their presence adds credibility to the analysis, providing insights into governance, oversight and risk management. In essence, they're the backbone of trust for investors, guiding them toward informed decisions.

While having independent board members is crucial for sound corporate governance, relying solely on this factor for investment decisions may not be prudent.

The importance of thorough research and analysis of fundamentals, including growth prospects, before making investment decisions cannot be emphasized more.

By doing your homework diligently, you can invest wisely and make informed choices that align with your financial goals.

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such. Learn more about our recommendation services here...