Do outside directors destroy value

Written by YRK Reddy | Updated: Jul 23 2005, 05:30am hrs
Do outside directors reduce the value of a firm There has been some puzzling evidence from US academic circles that there is a negative correlation between their numbers and firm value. There is also a conclusion that corporate performances do not improve for boards with more representation by independent directors and that outside directors could be pursuing a political agenda. If such conclusions are true for other countries as well, the proportion of outside directors may merit a closer examination.

Countries such as Japan, Korea, Spain and Italy prefer a majority of outsiders (i.e., non-executive directors), with a sufficient number that would qualify as independent. While the norm for independent directors are even slacker in some countries, such as Mexico, the preference in the UK, Australia, New Zealand and the US is that the majority be independent. Sebis preference for 50% is closer to this view. Contrarian to the Anglo-American view, the Irani committee would be happy with just one-third being independent. Ficci will be happier with 25%, leaving more space for the promoter shareholders. The minister for company affairs has opined that the matter of independent directors should be decided by the owners/shareholders.

The rationale for the number of independent directors should emanate from the assumptions behind the agency framework and their applicability to India. In the US, there are very few companies with blockholding/dominant shareholders. There are too many passive ownerssmall investors and managers who represent mutual funds, pension funds, insurance companies, etc. In fact, there is growing concern to promote ownership that monitors management better. As The Economist commented some years ago, in the Anglo-American system there are punters, not proprietors. On the other hand, a vigilant, competent and transparent blockholder could do a better job of governance at a far lower transaction cost for the equitable benefit of all.

India Incs preference for a smaller number of IDs is not without merit
They can crowd out active governance by those who may have more at stake
However, two dangers justify the presence of independent directors in countries like India, whatever the number. First, the dominant shareholder, who is also in control of the management, may tend to indulge in tunnelling, self-dealing, insider trading and exploit conflicts of interest for private benefits.

Of course, there is little evidence that independent directors actually prevent this. As true independence cannot be enforced by regulation, dominant shareholders obviously ensure director capture far ahead of their nomination. They may actually induce such directors to become party to such insidious activities. Despite the poor experience, the triumphant hope is that they will act as wise counsel.

The second is that the dominant shareholder may be insulated from specialist knowledge and strategic thinking that can be brought in by expanding the Boards with competent outside directors. This has been proved in many sunrise industries and those in the restructuring mode.

There is no unanimity on the ideal numbers of outside and independent directors, either among nations or researchers. The prescription of independent directors is like a health tonic that will do general good in moderate measure. They are required, at least, to bring in the climate and aspiration of independence. However, too many independent directors may bring little additional benefit to companies which are actively monitored, transparent and accountable. They may even crowd out active governance by those who may have more at stake.

Overall, the contrarian preference of India Inc, for a smaller number of independent directors than what Sebi wants, is not without merit. In the absence of the widely-held corporation and the continued control of management by the dominant shareholders, too many independent directors may only increase the transaction cost. At worst, they may even mask the illegitimate activities of the dominant shareholders with their reputation and contribute to the decline of the firm. Sometimes, the general tonic can be intoxicating if taken in large measures.

As large doses of independent directors are no cure-all, shareholders, particularly the active institutional investors, may be best positioned to recognise the specific needs of the company and use independent directors as therapeutic interventions.