EGMs of Tata Companies - Some Reflections

Small investors lack capabilities, resources and motivation to exercise the voting right in general meetings. But block holders (those who hold more than 5 percent shares) and institutional shareholders have the capacity and resources to analyse the outcome of a proposal on the performance and governance of the company. Therefore, it is their solemn duty to exercise the voting right. However, institutional shareholders sometimes abstain from voting. Even in highly publicised and high voltage EGMs of Tata companies, which were held in December 2016 to remove Mr. Nusli Wadia as independent director, voting by institutional shareholders was 75.02 percent in Tata Steel, 69.23 percent in Tata Motors and 57.08 percent in Tata Chemicals. This implies that some institutional shareholders abstained from voting. With electronic voting, the cost of exercising the voting right is almost zero. Therefore, the only reason for abstaining is that the institutional shareholder does not want to take a position, for example, in a controversial issue or where two powerful groups are involved, as voting either way might hurt its own business interest. But in the process it hurts the interest of its shareholders, unit holders or policyholders, as its return on investment in the investee company depends on the quality of governance and management of the that company. At the macro level, abstaining from voting hurts the country, as shareholder activism improves the quality of corporate governance in the country. As the institution on independent directors is inherently weak, only shareholder activism can protect minority interest and interest of other stakeholders.

As on September 30, 2016 the promoter group controlled 32.43% of Tata Motors, 31.35% of Tata Steel and 30.80% of Tata Chemicals. On December 13, Tata Group acquired additional 1.73 per cent shares in Tata Motors. Therefore, there is no surprise that resolutions to remove Mr. Wadia were passed with significant majority. In case of Tata Steel 90.80 percent of votes polled were in favour of removing Mr. Wadia. The same was 71.20 percent in case of Tata Motors and 75.67 percent in case of Tata Chemicals. Had the company law required special resolution (three-fourth majority) for removing an independent director, Mr. Wadia could not be removed from Tata Motors and in case of Tata Chemicals it would have been a close call. It might be appropriate to debate whether, in order to protect the independence of independent directors and to strengthen the institution of independent directors, the law should require a special resolution for the removal of independent directors.

Primary responsibility of independent directors is to protect the interest of non-controlling shareholders (commonly called minority shareholders). Therefore, it is appropriate that minority shareholders should have significant say in the removal of independent directors. For example, in case of Tata Chemicals, 51.45 percent of votes of institutional shareholders went against the resolution for the removal of Mr. Wadia, but that was not reflected in the overall result. In case of Tata Motors, institutional shareholders were almost equally divided in favour of and against the resolution. 49.94 percent of votes of institutional shareholders went against the resolution. However, the story was different in case of Tata Steel. 82.48 percent of votes of institutional shareholders went in favour of the resolution.

When the controlling shareholder proposes to remove an independent director, its 100 percent vote is polled in favour of the resolution. Therefore, it is easy to pass an ordinary resolution (simple majority). For example, if 30 per cent shares are held by the controlling-shareholder, the ordinary resolution will be passed, even if all public shareholders vote and 70 percent of their votes go against the resolution.

It is reasonable to assume that 70 percent vote of institutional-shareholders and 5 percent vote of public shareholders (other than institutional shareholders) are generally polled. In that situation, if institutional shareholding is 40 percent or less, the resolution will be passed as ordinary resolution even if all the votes of institutional shareholders and other public shareholders go against the resolution.

With those assumptions, if, institutional shareholders hold 10 per cent or less voting rights, the resolution will be passed as special resolution even if all public shareholders (including institutional shareholders) vote against the resolution. If, institutional shareholders hold 40 per cent voting rights, the resolution will be passed as special resolution even if around 50 percent of votes of public shareholders (including institutional shareholders) go against the resolution.

Therefore, there is a strong case for mandating that the resolution for the removal of independent directors should be treated as ‘special resolution’.  

Independent directors - inherently weak institution

Tata Steel, Tata Motors and Tata Chemicals will hold extra-ordinary general meetings (EGM) in December 2016 to remove, at the request of Tata Sons, Nusli Wadia and Cyrus Mistry from the board of directors (here after ‘Board’). Nusli Wadia is an independent director and Cyrus Mistry was removed as the chairmen of Tata Sons on October 24, 2016. Removal of an independent director through the formal process of passing a resolution is unprecedented.

The Companies Act 2013 provides that shareholders may remove a director before the expiry of his term by passing an ordinary resolution in a general meeting. The concerned director has the right to make representation before the shareholders.

Tata Sons’ move to remove an independent director shows the weakness of the institution of independent directors. The most important role of independent directors is to protect the interest of non-controlling shareholders (also called minority shareholders). They are expected to protect minority shareholders from strategies and other decisions of the management that are detrimental to the interest of the company. Therefore, situations might arise in which independent directors do not support the proposals placed before the Board. In that situation, the controlling shareholder can easily get rid of the dissenting independent directors. Removal of all the dissenting independent directors together gives a signal to the market that something is wrong in the company. Therefore, the controlling shareholder, to subdue dissenting voices, would remove that independent director who assumes the leadership role. Usually a polite request to resign works, as independent directors lack the motivation to take the role of a crusader. If that does not work, the controlling shareholder, like Tata Sons, can make the Board to call an EGM and remove the dissenting independent directors. Removal requires simple majority of all those who vote on the resolution. If, the controlling shareholder holds more than 50 percent of voting right, resolution would certainly be passed. Even if the controlling shareholder has less than 50 percent voting right, the resolution is likely to be passed, as non-institutional shareholders lack enthusiasm for voting in general meetings. Only if the institutional shareholding is substantially high, as in the case of Tata Steel (institutional shareholding 42% against promoter’s holding of 32%), institutions’ voting is key in passing the resolution. Rationally, an institutional shareholder should vote in the interest of the company rather than siding with the controlling shareholder blindly unless its internal governance is weak. However, if consensus cannot be reached among institutional shareholders to vote against the resolution, the probability of passing the resolution remains high.

Tata Sons alleges that Nusli Wadia was ‘galvanizing other independent directors against Tata Sons’. This is a curious allegation. Every independent director is a leader and develops his/her own perspective of the situation and develops his own views on how to address an issue. It is natural that in a separate meeting of independent directors, every independent director will try to build a consensus around his view/solution, which he/she considers the best alternative. In the meeting, independent directors listen to each other and may change their views. But it is not necessary that a consensus will be reached. If the view of a particular independent director does not fit into the scheme of the controlling shareholder, he may always be accused of ‘galvanizing other independent directors against the controlling shareholder’, because of his/her efforts to build consensus around his/her view. This cannot be a good reason for removing an independent director.

SEBI (Listing Obligation and Disclosure Requirements) Regulations 2015 requires that if the chairperson of the Board is a non-executive director at least one-third of the Board shall comprise of independent directors and if the entity does not have a regular non-executive chairperson, at least half of the Board shall comprise of independent directors. In absence of consensus, Board decisions are taken using majority rule. Non-independent directors are subservient to the controlling shareholder. Therefore, even if majority of independent directors do not support a decision, the Board can approve the same with the support of some independent directors.

In a family business and in companies in which there is concentration of ownership, independent directors are, at best, effective sounding boards for the management. They cannot protect the company’s interest effectively. Tata Sons by its move to remove Nusli Wadia is creating a bad precedence that will further weaken the inherently weak institution of independent directors. It gives credence to the general belief that only those independent directors, who maintain cozy relationship with the controlling shareholder, survive.

Managing complexities in corporate governance

Tata Sons is a private limited company that controls Tata Group companies. This is a 148 years old $100 billion conglomerate with large number of private limited companies and 29 listed companies. In some large listed Group companies the promoter (Tata Sons and others) holds less than 50 per cent voting rights (e.g. Tata Motors 32.45% and Tata Steel 31.55%). Sir Dorabji Tata Trust and Sir Ratan Tata Trust along with some other Tata Trusts hold 66% stake in Tata Sons. Mistry's family, the Shapoorji and Pallonji Group, owns 18.5% stake in the company. Sir Dorabji Tata Trust and Sir Ratan Tata Trust have powers to appoint or remove a chairman of Tata Sons with their own three-member quorum of the selection panel. Ratan Tata chairs those two trusts.

Abrupt removal of Cyrus Mistry from the position of the chairman of Tata Sons, on October 24, 2016, was an unusual event. In India or elsewhere the board of directors (hereafter board) seldom sacks the CEO so abruptly. Ratan Tata, who is the patriarch of the family that founded the Tata group, has come back as interim chairman. Earlier he served as chairman for two decades. Tata Sons saga is not about clash for power. It is not about ego clash between two individuals. It is about managing complexities in corporate governance.

Tata group has 4.1 million shareholders. Shareholders and other stakeholders have a right to know why Mr. Mistry is removed. Unfortunately, Tata Sons has not communicated clearly the reasons for his removal. Good corporate governance requires high level of transparency. Shareholders and stakeholders have a right to get adequate information on important decisions and group’s operating policy. Maintaining right level of transparency is a challenge in corporate governance. It is often difficult to assess how much to disclose publicly so that the group/company is not hurt while shareholders and stakeholders receive adequate information.

From the narratives in media it appears that Mr. Mistry was handling things differently from the way things were handled by Mr. Tata. This difference in approach frustrated Mr. Tata and it has lead to the removal of Mr. Mistry. A CEO who cannot get along with the controlling shareholder cannot survive. Therefore, true professionalization of a family business is difficult unless the family takes a hands-off approach and gives ‘free hand’ to the CEO. It is not easy. Succession planning, in general, is a challenge in a family business. For smooth transition, the family governance should be good and a successor from within the family should be identified early and he should be groomed over years. The problem magnifies if none within the family is available to take up the baton. It is difficult to get an outsider who will be in tune with values, ethos and business approach of the family. Mr. Mistry is not exactly an outsider. He is related to the Tata family through marriage and his family has significant shareholding in Tata Sons. He is a director in Tata Sons since 2006 and was groomed for a year, yet Mr. Tata developed the conviction that Mr. Mistry was not in tune with the values, ethos and business approach of the Tata group.  

With hindsight some strategic choices made by the Tata group appears to be wrong. It might be that some of those choices were driven by Mr. Tata’s aspirations and passion, rather than by sound economic rationale. It is not uncommon that in a company where there is concentration of shareholding, corporate strategy and business strategies are driven by the personal aspiration of the controlling shareholder. Quite often, after long deliberations, the board rationalises the strategic choices of the controlling shareholder. This hurts the interest of non-controlling shareholders, particularly if the controlling shareholder focuses on empire building rather than on value creation.

On November 4, 2016 all the seven independent directors of India Hotels Company Limited (IHCL), in which the promoter holds 38.65 per cent shares, reposed full confidence in the leadership of Mr. Mistry. They praised the steps taken by him in providing strategic direction and leadership to the company. They communicated their views to the Bombay Stock Exchange (BSE). If, boards of other companies, in which the Tata Sons holds less than 50 per cent voting rights, act similarly, the relationship between those operating companies and Tata Sons shall be redefined. It is difficult to assess whether this will benefit or hurt the non-controlling shareholders of operating companies.

As the events will unfold in coming days, we shall develop better understanding of how the group will operate in future.

Rotation of auditors - its side effects

The Companies Act 2013 has introduced important audit reforms. One of the important reforms is rotation of the auditor. All listed companies, unlisted public limited companies having paid up share capital of Rs ten crore or more, all private limited companies having paid up share capital of Rs twenty crore or more, and all companies having public borrowings from financial institutions, banks or public deposit of Rs fifty crore or more are required to rotate their auditor. An individual cannot continue as an auditor for more than one term of consecutive five years and an audit firm cannot continue as an auditor for more than two terms of consecutive five years, that is a consecutive period of ten years. The cooling off period is five years. The Companies Act allows three-year time for complying with the provision. Therefore, the provision must be complied by April 1, 2017. The objective is to enhance the audit independence. This is expected to improve audit quality resulting in improved financial reporting.

Traditionally companies do not change their auditors except in exceptional circumstances. In Large number of companies that are required to rotate the auditor, auditors have already completed more than ten years/five years of providing auditing service. Those companies will change their auditor effective from 2017-18.

Local firms dominate Indian audit market. However, the presence of Big 4 audit firms (Deloitte, PWC, E&Y and KPMG) cannot be ignored. Big 4 are the largest professional service network in the world. They provide audit, assurance, tax, consulting, advisory, actuarial, corporate finance and advisory services. In India, they cannot provide audit services directly. Therefore, they provide services through network of local firms. It is alleged that they flout the rules in order to provide audit and assurance services. Many foreign investors put a condition that the auditor of their choice should be appointed. This helps the Big 4 audit firms to grow in India.

Local firms audit 62 per cent of the BSE five hundred companies. There is an apprehension that many companies that get their accounts audited by local firms will appoint one of the Big 4 or other large international professional service network (e.g. BDO, RSM, Grant Thornton and Baker Tilly) as their auditors. If that happens, the local firms will lose out. It is reported that large 20 local firms have written to the government to intervene to protect their interest. On September 30, 2016, the Ministry of Corporate Affairs has notified constitution of a three member expert group to look into the complaint that Big 4 are circumventing rules and to find ways to help local firms.

Most local firms are small and they do not face any threat from Big 4 and other international firms. They are mostly located in tier II and III cities and small towns. They provide variety of services to small companies. They lack aspiration to become big.  Big 4 and other international firms engage members of the Institute of Chartered Accountants of India (ICAI) to deliver audit and assurance services. In this context, presence of Big 4 firms does not hurt the auditing profession. Therefore, it is debatable whether there is a case for government’s intervention to protect local audit firms.

A proposal is taking round that the government should mandate joint audit with at least one local auditor to create professional opportunities for local firms. This is unwarranted. This will increase the auditing expenses. The audit committee of a company should assess the need for the joint audit and the company should decide whether it should have joint audit. No rule should be framed to create jobs for a profession, particularly for one that is matured.

Chartered Accountants are prohibited from soliciting professional work through advertisement or otherwise. But they can respond to tenders. The practice of issuing tender for the appointment of internal auditors is quite common among public enterprises. Such a practice is not common among private-sector companies. Companies usually do not issue tender for the appointment of statutory auditors. Tendering is the right method to search for the right audit firm. This increases the choice and reduces auditing cost through competition. Companies should not limit their choice to Big 4 and other international firms or a few large local audit firms. There are local firms that have capabilities to audit large and complex transactions. Search through tendering process would help to identify such firms.

It will be interesting to see how the new rules regarding rotation of auditors will actually impact the auditing profession.

Boards must adopt integrated reporting framework

BOARDS MUST ADOPT INTEGRATED REPORTING FRAMEWORK

International Integrated Reporting Council (IIRC) had issued the Integrated Reporting Framework in December 2013. Integrated report communicates the complete story of value creation concisely to enable investors and other stakeholders to assess the ability of the company to create value over long term. It tells how an organization's strategy, governance, performance and prospects, in the context of its external environment, lead to the creation of value in the short, medium and long term. Enlightened-companies use the term ‘value’ in much broader sense than what is understood by the term ‘shareholder value’. Shareholder value is created when the company is able to generate return on financial capital that is higher than the cost of capital over a long period of time. Enlightened-companies realise that the ability to create shareholder value hinges on the ability to create societal value. This perception is captured in the Companies Act 2013, which states: “A director of a company shall act in good faith in order to promote the objects of the company for the benefit of its members as a whole, and in the best interests of the company, its employees, the shareholders, the community and for the protection of environment.”

Integrated Reporting Framework identifies six types of capital (resources) that companies use to create value. Those capitals are, financial capital, manufactured capital, intellectual capital, human capital, social and relationship capital and natural capital. Those include capitals that are not owned or controlled by the company. For example, manufactured capital includes roads and other infrastructures not owned or controlled by the company. None owns some items of natural capital (e.g., clean air). Companies through its activities and outputs create, reduce and transform capitals. A business model is sustainable only if it results in accretion to the net value, taking all the capitals together. Therefore, the management and the board of directors (here after, Board) need to understand the interdependencies and tradeoffs between various capitals and how their availability in future would affect the long-term sustainability of the business model.

One of the guiding principles in the Integrated Reporting Framework is ‘connectivity of information’. Connectivity of information is logical. It is about connectivity between: external environment; governance, opportunities and risk, strategy and resource allocation, business model, performance, and, future outlook; past, present and future; the capitals; financial and other information; qualitative and quantitative information; management information, Board information and information reported externally; and information in the integrated report, information in company’s other communications and information from other sources.

Connectivity of information can be achieved only through ‘integrated thinking’. Integrated thinking refers to holistic approach in decision-making. The Integrated Reporting Framework describes integrated thinking as, “The active consideration by an organization of the relationships between its various operating and functional units and the capitals that the organization uses or affects. Integrated thinking leads to integrated decision- making and actions that consider the creation of value over the short, medium and long term.”

In addition to establishing right processes, changes in behaviours, culture and leadership styles are required for implementing ‘integrated thinking’. Sharing of information across the organisation and consideration of fresh perspectives presented by employees in decision-making are essential for integrated thinking. These require building greater trust between leaders and employees. Close collaboration between different units and functions are required to draw right knowledge and experience and develop holistic view in decision-making. Strengthening the engagement with external stakeholders is necessary to understand stakeholders’ perspective and value in order to ensure that the strategy is sustainable for the long term in changing external contexts. Transparency in decision-making is necessary to develop a shared understanding the business model and broader strategy to enable employees to work for a common goal.

The concept of ‘integrated thinking’ is logical and simple, but it is challenging to apply the concept in practice. The traditional mind set of focusing on shareholder value, financial information and quantitative data and hierarchical leadership style make adoption of integrated thinking difficult. It takes years to fully embed integrated thinking in decision-making. The Board has to take the responsibility of overseeing that the company is moving towards developing necessary processes and culture to support integrated thinking. The Board should deliberate on all material factors that significantly affect the ability of the company to create value in the short-term, medium-term and long-term. It might be a good idea for Boards of companies to start the journey by adopting Integrated Reporting Framework for internal reporting to the Board. Companies should aim issuing integrated report to investors as early as possible in order to build trust with wider stakeholders.

Boards should Focus on Disclosures and Auditors’ Independence

When, in the recent quarter, performance of Infosys failed to meet the market expectations, the media reported it as the first failure of Vishal Sikka, who is the CEO of the company. The media gives total credit for the consistently excellent performance of ITC to Yogi Deveswar, who is the Chairman and CEO of the company for quite a long time. Cyrus P Mistry had revised the strategy of the Tata Group, when he took over as the chairman of the Group. It is obvious that the media and the market believe, and rightly so, that the Board does not contribute significantly in the performance of the company. The leadership qualities and managerial capabilities of the CEO (and his team) determine the performance. In case of companies, where the controlling shareholder runs the company directly or through its nominee, the performance of the company reflects the quality of decision-making by the controlling shareholder. The board of directors (Board) gives free hand to the CEO to manage the company not only because it is right to do so, also because independent directors’ understanding of the business is not adequate to give directions to the CEO. Therefore, in ‘good times’, the Board plays the game to give a semblance of some serious boardroom deliberations on strategy and other critical issues. Of course, competent directors provide some valuable inputs. When, product/service-market performance of the company shows continuous decline, the Board asks certain persuasive questions, to the best of its capabilities. Even in those situations, solutions come from an external consultancy firm appointed by the management or from the management itself. The Board adds some value while deliberating alternative solutions, only if the Board is diversified and capable. Although, the Board remains passive, without intensive engagement with the CEO, when the going is good, it is worth building a diversified and capable Board, which can provide support to the CEO when needed. And in a crisis situation, advantage of collective wisdom can be obtained.

As the he Board gives freehand to the CEO, it is expected to play an important role in the selection of the CEO and his/her team. In this regards, the role of the Nomination and Remuneration Committee (N&RC) of the Board cannot be overemphasised. The Companies Act requires that every listed company, every public company with paid up capital of ten crore rupees or more or turnover of one hundred crore rupees or more and every public company having, in aggregate, outstanding loans, or borrowings, or debentures, or deposits exceeding fifty crore rupees shall constitute a N&RC. The committee consists of at least three non-executive directors, out of which not less than one-half should be independent directors. N&RC has the responsibility of identifying persons who are qualified to become directors and who may be appointed in Senior Management. It is also responsible for developing remuneration policy for directors, key managerial personnel (KPM) and other employees. SEBI (Listing Obligations and Disclosure Requirements) Regulations 2015 further requires, among others, that the Committee should devise a policy to diversify the Board. Unfortunately, companies, except some large and good companies, have adopted the tick-box approach in complying with provisions related to N&RC.  Therefore, in practice, engagement of N&RC, and consequently the Board, in the selection and appointment of directors, CEO, KMPs and employees in the Senior Management is minimal.

In practice, the Board does not have substantive involvement either in people management or in the formulation and implementation of strategy. Therefore, it should allocate its time to corporate governance issues, rather than spending more time to review strategy and performance in appearance only.

Investors and other stakeholders are not so much concerned about what is happening within the Board. In any case, that is unobservable. They evaluate the quality of corporate governance by catching signals and symptoms. For example, they evaluate the level of transparency accountability and equity adopted by the management; quality of family governance (e.g., dispute resolution and succession planning); leadership quality of the CEO and the leadership pool within the company; legal proceedings against the company; qualifications in the audit report; relationships between the CEO, promoter and the Board; relationships of the management with stakeholders; reported management fraud; and company’s resilience to quickly respond to the changes in the business environment. Boards should focus on those issues.

Unfortunately, Boards do not pay the desired attention to the quality and level of disclosures in various internal and external documents; and independence of statutory auditor and internal auditor. Boards are required to shift the focus.