Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

© Prof. Jayanth R. Varma
jrvarma@iima.ac.in

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Sat, 22 Jun 2019

Allowing a corporate body to be a director

A few months back, Joseph Franco published a fascinating paper about a commoditized governance model adopted by a small minority of US mutual funds where the entire governance is outsourced to an unaffiliated entity that specializes in providing governance services. (Commoditized Governance: The Curious Case of Investment Company Shared Series Trusts (February 14, 2019). 44 J. Corp. L. 233 (2018) ; Suffolk University Law School Research Paper No. 19-7. Available at SSRN: https://ssrn.com/abstract=3334701). Franco concludes that this model is merely an interesting curiosity:

Where a board’s role primarily involves organizational, rather than strategic, oversight of an underlying business, as in the fund industry, commoditized governance may prove attractive for at least some industry participants. In contrast, where a board’s role encompasses both organizational and strategic oversight of an underlying business, as is more commonly the case, commoditized governance will not be a successful governance model. Accordingly, and consistent with practical experience, commoditized governance will exist largely as an exceptional, rather than common, form of entity governance.

This discussion got me thinking about a related idea – would it make sense to let specialized unaffiliated corporate bodies (like LLPs, LLCs or private companies) to become independent directors of large companies? (I do not want to contemplate the recursion involved in letting the independent director be another listed company.)

The current model of allowing only individuals to become independent directors is not working well. First of all, most independent directors have quite meagre wealth, and so when things go wrong, investors can recover virtually nothing by suing the independent directors (They gain much more by suing the auditors or other gatekeepers). At the same time, prosecutors and regulators are very keen to punish the directors, and this keenness often depends more on the quantum of the loss and less on the degree of negligence of the director. This means that highly risk averse people would be reluctant to become independent directors. If the only people willing to serve on the board are those with a high degree of risk tolerance, then the companies that they govern would naturally tend to pursue high risk strategies as was well illustrated by the Global Financial Crisis of 2008.

Second, most independent directors lack the administrative and analytical support that is often needed to challenge management strategy at a fundamental level. Almost all independent directors can only envy the massive support that non independent directors (venture capitalists, private equity firms, activist investors, nominees of the lenders and representatives of controlling shareholders) get from their respective organizations. Unfortunately, these well endowed non independent directors are often more interested in looking after the interests of their respective constituencies, than the interests of the company itself or its shareholders as a whole.

The governance deficit that we observe in some of the largest companies in the US, in India, and elsewhere in the world, is symptomatic of these fundamental problems of the current model of relying on individuals to serve as independent directors. I think there is much to be gained by shifting to a model of incorporated independent directors. This will also make it easier to impose capital adequacy and skin in the game requirements. Valuation metrics in the financial services industry (for example, asset managers and rating agencies) suggest that a large incorporated independent director service provider would command a valuation of 5 10 times revenue. If independent directors are paid 0.5 1% of profits, and each incorporated independent director serves on boards of 30 100 large companies, then the independent directors of a company would probably have a combined valuation of twice the annual profits of a large company. That would represent a juicy litigation target for shareholders who suffer losses due to a governance failure (probably a more juicy target than the auditors). The large franchise value of the business would motivate these incorporated independent directors to exercise a high degree of diligence in performing their work, and would also make them highly sensitive to reputation risk. Would this not be a major improvement over the current system?

Posted at 15:32 on Sat, 22 Jun 2019     View/Post Comments (1)     permanent link