Should employees get primacy in corporate governance?

Large number of jobs in the Information Technology (IT) sector is at stake. Automation and new technology are disrupting the industry. Skills that created value so far are becoming redundant. New skills are required to work with new technologies, such as, Big Data, artificial intelligence, Internet of Things, robotics and virtual reality. Companies have started up-skilling existing employees and recruiting those with required skills. Employees, who are unable to acquire new skills, are losing jobs.

In the above context two questions have emerged. The first question is whether it is better for the top management to take pay cut rather than to layoff employees in difficult years. The other question is whether IT employees should form union to protect their interest when the going is tough. The first question is relevant when the job loss is due to a slow down, which is transitory. In that situation, the pay cut by the top management will be for a short period in order to retain the talent that will be used after the bad period is over. It is not relevant when jobs and skills become redundant due to disruption caused by technological advancement or some other mega event. The second question is relevant in all situations from the perspective of employees. Bargaining power is relevant in all types of negotiations and collective bargaining is desirable when individual bargaining power is low. Protecting the job during tough times or securing adequate compensation when a job is lost requires hard negotiation with the employer. Therefore, it is no surprise that employees, including IT employees, have the propensity to form union.

There are no straight answers to both the vexed questions. 

Although the IT industry is in focus at present, such disruptions occur in almost all industries with fast changing technological, social and geo-political environment. Therefore, it is appropriate to examine the issue from the perspective of corporate governance.

Companies create value through its operations while complying with law and social norms, and taking care of the social and environmental concerns. A very small portion of the value is shared with socially and/or economically marginalised population of the society through Corporate Social Responsibility (CSR). Shareholders, customers, providers of inputs (including human capital and debt capital), and government share the value created by the company. Government gets its share through direct and indirect taxes. Companies, through industry associations or otherwise, lobby with governments to reduce their share of the value. The share of customers and input providers in the value created by the company depends on the market forces and their relative bargaining power vis-à-vis the company. The share of shareholders is the residual amount. Shareholders’ primacy is well established in corporate governance. Therefore, companies focus on creating ‘shareholder value’ while being ethical and fair to other stakeholders. There are two reasons for the same. First, financial capital is sticky in the sense that once invested in non-financial assets (such as, plant and equipment) to build capacity, it cannot be recovered without substantial loss. Second, the non-controlling shareholders after entrusting their fund to the company cannot participate in strategic and operating decisions. In absence of focus on creating ‘shareholder value’ and effective monitoring, the management might misallocate the resources causing depletion of shareholders’ wealth permanently.

Human capital is also ‘sticky’ like financial capital. After completing substantial period of employment in a company, employees develop specialised skills, which are not useful in other industries. Consequently, their market value outside the industry is very low, almost zero. Similarly, when business model or technology changes many of those skills become redundant. Therefore, those who lose job due to change in the business model or technology cannot find an alternative employment. In this context it is important to consider whether employees should also be considered as a primary stakeholder along with shareholders. Companies should focus on both ‘creating shareholder value’ and ‘protecting and creating employee value’.

It is not enough to merely honouring the initial employment contract with an employee. It is important that employees are trained to acquire skills that would be needed in future, when the company sees disruption coming, that is, much before the disruption occur or the company plans to change the business model. Companies should ensure alternative livelihood for those who cannot acquire new skills, particularly if they are low-paid employees.

The issue is complex, particularly because companies engage large number of employees on short-term contracts and off-role. It deserves serious debate among academicians, regulators and practitioners of corporate governance.

Is investing in tobacco business unethical?

The Bombay high court will hear a Public Interest Litigation (PIL) filed by two Tata Trusts trustees along with five others against the union government, the Insurance Regulatory and Development Authority of India (IRDAI), LIC and other state-run insurance companies. The PIL called on the high court to direct the public sector insurance companies to divest their shareholding from the companies that are directly and indirectly engaged in the tobacco businesses. The PIL argues that investment by those companies in tobacco business is against the spirit and intent of the World Health Organization’s Framework Convention on Tobacco Control (WHO FCTC), which is the health treaty developed in 2003 in response to the globalization of the tobacco epidemic. India became a partner of the treaty in 2005.

Tobacco consumption causes estimated six million deaths per year globally, of which one million are in India.  The production-related health hazards from tobacco are also a matter of serious concern. Tobacco farmers, farm-workers, and bidi workers suffer from occupational illnesses like ‘green tobacco sickness’ (GTS).  Tobacco consumption also has severe societal costs due to reduced productivity, health cost burden and environmental damage.

The government, in conformity with WHO FCTC, has framed laws and taken steps for reducing tobacco consumption and creating awareness about health hazards. It is also working on reducing tobacco farming by developing economically beneficial alternative crops and vocations for tobacco farmers. Results are visible, although the progress is quite slow.

In spite of the disastrous health hazard from tobacco consumption, an average investor would consider including investment in a company that is in tobacco business in her/his portfolio of investment. An average investor behaves rationally. Therefore, so long as she/he estimates that the company would continue to create shareholder value, she/he would consider investing in the company. She/he uses ‘environmental, social and governance’ (ESG) criteria to assess business risks of the tobacco business (say, risks from tighter government regulations, falling sales volume and activism against tobacco consumption) and factors in the same in valuing the company’s equity.

Is there any ethical or moral issue in investing in tobacco business, which is a legal activity? Ethical considerations transgress the legal boundary. Therefore, some argue that it is immoral and unethical to invest in the production and sale of those products, the production and/or consumption of which harms the society. ‘Ethical investing’ (also called socially responsible investment, or sustainable, responsible and impact investing) is an old concept. Ethical investing requires using ESG criteria, in addition to financial criteria, in deciding investment in a particular industry or a particular company. It uses ESG criteria not to assess business risks, but to assess impact of the business on environment and society. Investors who believe in ethical investing would not invest in so-called ‘sin’ industries (e.g., tobacco, alcohol, gambling and military weapons), the products or processes of which, in their judgement, are harmful to the environment or society.

I think whether to invest in companies operating in ‘sin’ industries is a matter of personal choice based on one’s own individual ethical standards. For example, an oncologist, who experiences the trauma of her patients, may believe that investment in tobacco business is unethical. Similarly, ethical standards of individuals are often developed based on prescriptions and proscriptions in scriptures of their religion. However, in general, it is not immoral to invest in a company, which is allowed to operate by the parliament, even if it operates in a ‘sin’ industry. Parliament, in its collective wisdom, allows certain business activities and prohibits some others after taking into consideration public opinion and socio-economic impacts and weighing social costs and benefits of a particular business activity at a particular point in time. For example, in 2016 the central government issued complete ban of manufacture and sale chewable tobacco and nicotine, while it continues to allow production and sale of other tobacco products like cigarette and bidi. Parliament, by allowing a business to operate, conveys social approval to the business. Investing in a company, which is engaged in a legal business and complies with applicable laws (including soft laws) and social practices, is not unethical, because it passes the ‘social legitimacy’ test. Rather, it is unethical to invest in companies, which adopt unethical practices and flout regulatory and social norms, irrespective of the industries in which they operate.

It is inappropriate to restrain the government or PSEs from investing in companies like ITC, which provides superior return on investment. LIC, as a custodian of policyholder’s money, should act like a rational investor in building the investment portfolio.

Integrated reporting and shareholder value

In February 2017, Securities and Exchange Board of India (SEBI) had issued a circular advising top 500 listed companies, which are required to publish Business Responsibility Report (BRR) annually as a part of their annual report, to voluntarily adopt integrated reporting from 2017-18. The International Integrated Reporting Council (IIRC) has issued Integrated Reporting Framework. IIRC is a global coalition of regulators, investors, companies, standard setters, the accounting profession and NGOs.

Integrated report is directed to investors, but is useful to other stakeholders as well.  It tells the complete story of value creation holistically in a concise manner. It provides investors with information that is relevant for assessing the sustainability of the business model of the company. Integrated Reporting Framework identifies five types of capital (resources): financial capital, manufactured capital, intellectual capital (including organisational capital), human capital, social and relationship capital, and natural capital (e.g., air, water, mineral, forest, bio-diversity and eco-system health). All the resources that a company uses to create value are not owned by it. For example, government or some third party might own infrastructure (e.g., ports and bridges) that is used by the company. Some natural resources (e.g. air) are not owned by anyone.  In the process of creating value the company transforms one form of capital into another form of capital and increases value of some capital while reducing that of others. A company creates value only if the net outcome is positive. The term ‘value as used in integrated reporting may be perceived as ‘social value’, which is the total of value created for shareholders and value created for other stakeholders. A business model that destroys social value is not sustainable. It is true that in most situations it is difficult to quantify the outcome, but a qualitative assessment is possible. Therefore, integrated report provides a blend of quantitative and qualitative information.

Integrated report focuses on future and describes how well the company is managing environmental, social and governance (ESG) issues. For example, integrated report provides insight into how the company is managing its relationships with its key stakeholders, including how and to what extent the company understands, takes into account and responds to their legitimate needs and interests. Similarly, it provides insight into how the business model affects natural capital.

Integrated report also provides information on how the firm integrates different components of the organisation and how it integrates short-term, medium-term and long-term strategies.

Integrated Reporting Framework requires that the report should include a statement from board of directors (hereafter board) that includes: an acknowledgement of its responsibility to ensure the integrity of the integrated report; an acknowledgement that it has applied its collective mind to the preparation and presentation of the integrated report; and its opinion or conclusion about whether the integrated report is presented in accordance with the Integrated Reporting Framework. Board’s involvement with the preparation of the integrated report adds value to the board’s performance as it compels the board to understand the complete process of value creation and ESG issues and inculcates the culture of ‘integrated thinking’. This culture percolates down to the lower levels in the organisation.

The construct of ‘social value’ is not in conflict with the construct of ‘shareholder value’. The fundamental value (also called intrinsic value) of a business does not depend on its ability to generate short-term profits. It depends on the perceived ability of the business to generate free cash flows (FCF) over a long period. FCF refers to the cash flow that is available to owners for spending on purposes other than the business purposes. If forces (e.g., government, pressure groups, regulators, courts of law) that relate to ESG issues are going to be material to the business, the board, management and investors have to worry about those and the board and the management have to decide what to do about those issues. Eventually, those things will affect FCF. Therefore, a company that fails the address ESG issues and does not create ‘social value’ would not be able to create the shareholder value.

Integrated report is an excellent tool to communicate to investors clearly how the company is managing ESG issues. In absence of that clear communication the value of the equity in the capital market lags the fundamental value of the company, as investor perceives higher risks arising from poor management of ESG issues.

Integrated reporting is evolving globally. The SEBI move will accelerate the evolution. Over time, integrated report should replace Management Discussion and Analysis and Business Responsibility Report, both of which, at present, form part of the annual report. 

Infosys Saga - Issues in Corporate Governance

Infosys Limited, which is a global leader in IT technology and consulting, is in the news after the founder-shareholders, who together hold around 13 per cent of the outstanding equity shares, voiced their concern over certain corporate governance issues. A whistleblower has raised same issues in a letter to the SEBI. They relate to alleged overpayment in the acquisition of Panaya, in which Hasso Plattner, who is the cofounder of SAP (the company in which the CEO of Infosys Mr. Vishal Sikka worked earlier), had 8.33 per cent shareholding; and unusually high severance pay of Rs 17.38 crores (actually paid Rs 5.2 crores) to the erstwhile CFO (Rajiv Bansal), who, according to the whistleblower, initially was not in agreement with the acquisition of Panaya. According to N R Narayan Murthy, the highly respected founder of the company, the high severance pay could be ‘hush money’ to silence Mr. Bansal. Other issues raised by the founders are the significant pay-hike of Mr. Sikka, departure of a former compliance officer David Kennedy with significant severance pay and appointment of Punita Kumar Sinha, who is the wife of a minister in the central government.

Across the globe outside blockholders (large shareholders who do not occupy a position in the board or executive management) monitor the performance of the board and directly intervene, for example, by writing letters to the chairperson communicating suggestions and concerns or raising issues in general meetings. Therefore, intervention by the founder-shareholders of Infosys is not a surprise. The use of the public forum (e.g. Media) to raise issues is.

The allegation that the board had approved payment of ‘hush money’ to the former CFO in the form of unusually high severance pay is a very serious allegation. The board on its part got the issue investigated by a highly reputed law firm (Cyril Amarchand Mangaldas), which did not find any wrongdoing or cover up of wrongdoing. Ostensibly, the founders were not satisfied with the investigation. If, founders believe the high severance pay was ‘hush money’, they should have taken recourse to options available in the Companies Act. For example, they could call EGM for removing the chairman of the board and chairman of the nomination and remuneration committee from the board. Indicting the board for wrong doing and pressurizing the chairman to resign by making noise in the media is an undesirable shareholder activism, which harms the company more than benefitting it.

Excessive compensation to the CEO and members of senior management is always an issue in corporate governance. The board has the responsibility to critically examine the employment contracts with them before approval. The Infosys board has indirectly accepted that high severance pay to former CFO was an error. This is definitely a failure of the nomination and remuneration committee.

Founders had expressed concern about the increase in the ratio of CEO salary to the median salary. Although it is generally believed that the high ratio reflects poor corporate governance, there is no norm. High ratio of CEO’s pay to median pay is not always against the principle of ‘fairness to all employees’. An independent board should apply its judgement based on the demand and supply of capabilities that are required for different positions/jobs for strategy implementation. Usually the board benchmarks salary with salary levels in comparable companies. For example, as Mr. Sikka has an opportunity to work for a global company in a similar position in USA and he is allowed to operate from USA, his compensation should be comparable to a CEO in a global IT company operating from USA. On the other hand, salary of employees located in India should be comparable to salaries in global IT companies operating from India. It could be the reason that the ratio of Mr. Sikka’s compensation to the median compensation in Infosys has exceeded the earlier normal.

It goes without saying that if the SEBI finds truth in the whistleblower’s allegations of unethical practice, the board should be held responsible. On the other hand it would be a mistake to hold Infosys hostage to its founders’ original approach to business. A ‘way of doing business’ is not the same thing as ‘core values’ like a commitment to integrity and ethical standards, mutual respect and fairness to all stakeholders. The latter should certainly not change. But to raise a certain way of doing business to the same status as these fundamental values can only do a disservice to the company and leave it without the ability to adapt to changing business contexts.

Will SEBI Guidance Improve Board Evaluation?

The Companies Act 2013 and the Securities and Exchange Board of India’s (SEBI) (Listing Obligation and Disclosure Requirements) Regulation 2015 mandate Board evaluation, which is the evaluation of the functioning of the board of directors (hereafter Board), evaluation of the chairman, individual directors and the board process. Companies Act requires that every listed company and every other public company having a paid up share capital of twenty five crore rupees or more at the end of the preceding financial year shall include in Board report a statement indicating the manner in which annual Board evaluation has been made.

Board evaluation is an effective tool for improving Board performance. It is a kind of self-evaluation. Like any other knowledge group, the Board evaluates its performance periodically to identify areas for improvement and develop an action plan to improve the performance. Another objective of evaluating individual directors is to identify under-performing directors and to weed them out. A weak chairperson should also be removed.

In January 2017 SEBI has issued Guidance Note on Board Evaluation. The preamble says that the objective of the Guidance Note is to provide guidance to those listed companies, which do not have much clarity on the process of Board evaluation. Board evaluation is new in India, but it is decades old in USA, Europe and some other parts of the world. Literature on Board evaluation is easily available. Any company that is serious about Board evaluation can develop and implement the process by going through the available literature. Moreover, there are professionals who advise companies in developing and implementing the process of board evaluation. Therefore, the lack of clarity cannot be a reason for not implementing Board evaluation in the right spirit. Those companies that have not implemented Board evaluation in true spirit are not serious about it.

Board evaluation is meaningful only if the Board is empowered for doing what it is expected to do – to guide and advise the executive management (the CEO and his/her team), monitor it in order to protect the interest of non-controlling shareholders (also called minority shareholders) and facilitate net working with external resources. Board evaluation improves the performance of even those Boards, which focus on the advisory role rather than the monitoring role.

It is wrong to assume that every public company is motivated to develop and implement an effective Board evaluation process.

In family-managed companies the dominant shareholder monitors the executive management closely and does not require the Board to monitor it. In most of those companies, the dominant shareholder appoints and if necessary, removes the CEO, Key Management Personnel (KMP) and the members of the senior management team. The Nomination and Remuneration Committee (NRC) does not play any significant role in this regard, although the Companies Act has made NRC responsible for the same. Similarly, the NRC does not play any significant role in the appointment and removal of directors and in succession planning. NRC approves the decisions of the dominant shareholder. In those companies, the dominant shareholder takes strategic decisions, as he/she understands the business and its environment much better than independent directors and relies on his/her entrepreneurial spirit and business acumen, rather than on the collective wisdom of the Board. Minority shareholders expect the Board (read independent directors) to protect their interest from the opportunistic behaviour (e.g., tunneling of funds for self-enrichment) of the dominant shareholder. But in those companies, independent directors are not independent, as they are selected by the dominant shareholder and enjoy the office at his/her pleasure. The dominant shareholder does not want an effective monitoring by the Board.

In most family-managed businesses, the Board is an ornamental Board. The dominant shareholder selects independent directors from professionals drawn from diverse fields to add to the ornamental value of the Board. The Board discusses routine matters (e.g., performance evaluation) at great length, spends less time on important issues (e.g., strategic issues) and ultimately approves whatever proposal is presented before it. Ornamental Boards do not have an urge to improve performance. The dominant shareholder does not see any value in Board evaluation. The focus is on family governance and family values.

Some family businesses, which operate in a volatile, uncertain, complex and ambiguous (VUCA) business environment, or want to attract institutional investors and foreign capital, are motivated to adopt good corporate governance practices and build an effective Board. SEBI Guidance will help them to improve the Board evaluation process. Others will use it as a reference point just for preparing the disclosure in the Board report without implementing Board evaluation seriously.