Independent Director: Burden or Success Factor?
The First Summit of the CIS Independent Directors – that was the name of the forum held in November in Almaty by the Kazakh Association of Independent Directors, the Russian Association of Independent Directors, and the VIPromotion Agency of Corporate Communications. The organisers said that the forum was aimed to support the initiative of the Kazakh government to advance the institute of independent directors in the country.
It should be noted that our government has displayed this initiative in a rather explicit way. In May 2007, the Law On Joint stock Companies was amended with a requirement that at least one-third of the board of any Kazakh joint stock company must be independent directors. According to the State Register of Registered-Issue Securities, out of 2,329 joint stock companies existing in the country only 270 (or a little more than 11%) have complied with this requirement to date.
In international practice, the board of a typical company comprises nine to ten directors. Yet, according to our law, three is enough. Here comes a simple conclusion that, in the near future, domestic businesses will need 2,000 to 6,000 independent directors and, consequently, the list of “hot” vacancies will be added to with another position.
However, only a few companies understand the necessity of this institute today. According to Zhanat Alimanov, executive director of the Kazakh Association of Independent Directors, the summit was aimed to persuade owners and executives that independent directors are not an annoying burden, but a new opportunity for their businesses.
Independent directors is one of the key elements necessary to build an efficient corporate governance based on the principle of the triumvirate: owners (shareholders), top management (executive body), and the board of directors (supervision and control). The latter has the most important role in this system: the board determines key business activities of a company, takes strategic decisions, and controls and gives instructions to the executive body. Unfortunately, in practice, not all directors act in the best interests of shareholders; they often abuse their powers for the sake of personal benefits. That was the reason why it was proposed that a board should include independent members, who can exercise unbiased and fair judgements. Independent directors must protect the interests of all shareholders – both major and minor. An independent director is linked to a company with his or her directorship only. In other words, he or she has no material relationship with the company’s shareholders, officials or employees. This is the very thing that helps balance the interests of owners and top management.
The position of an independent non-executive director (INED) appeared in the 1980-1990s in the UK and the US in response to a series of scandalous bankruptcies of major corporations, the reason of which were bad faith actions on the part of the management and corrupt practices on the boards. Large investors – UITs, investment funds, trusts and banks that attracted money from the population – suggested that the chief supervisory body of companies should be enhanced with independent directors. Their functions were limited to continuous outside monitoring of the resolutions of the board and implementation of the same, and to protecting the interests of all groups of shareholders. Legislatively, the most stringent rules in regard to having independent directors on the board were adopted in the US: in 2002, after the seventh largest American corporation Enron has gone bankrupt, the country enacted the controversial Sarbanes-Oxley Act.
Depending on the structure of ownership in a company that has an INED on its board and on what shareholders he or she represents, an INED has four main functions:
an independent arbitrator in making strategic decisions;
a professional independent adviser in making decisions that require an authoritative judgement;
a representative of minor shareholders; and
an independent intermediary between management and owners.
As a rule, an INED is accountable to the general meeting of shareholders, i.e. to all owners of a company. In international practice, the main function of an INED in public companies is to guarantee and protect the rights of the minority.
The Kazakh law sets very simple requirements for INEDs: a nominee should be at least 21 years old and have no criminal convictions. In addition, an INED can be deemed independent if he or she is not, and has not been affiliated with the company during the past three years before he or she is elected to the board; is not affiliated with any affiliates of the company; is not subordinate to officials or affiliates of the company; is not, and has not been an auditor during the past three years and does not take part in audits.
… and Practice
For compelling reasons, corporate development has become a topical issue in Kazakhstan. The country is preparing to join the WTO and become one of the top 50 most competitive countries in the world. At the same time, an increasing number of domestic companies approach external capital markets and the government has bolstered its efforts to advance the domestic stock market. Because of globalisation, compliance with corporate governance standards has become somewhat of a “business card” for a company to show its foreign customers, partners and investors.
Financial institutions are the most advanced in this field. Banks are continuously supervised by a state regulator, whose main task is to maintain trust of investors and the population to the country’s financial market. Therefore, banks are obliged to have an efficient internal control and risk management system. The Basel Accords that are proactively introduced in the practice of second-tier banks plays an important role in this process. In addition, financial institutions face a vital need to attract loans, and implementing due corporate governance becomes one of the most efficient methods to raise one’s investment attractiveness.
The principles of corporate governance are effectively implemented by those domestic companies who have arranged IPOs abroad or are preparing to do so. International exchanges are interested in maintaining investors’ trust to their trading floors, which is why they require that the boards of listed companies include independent members. Issuers also have a direct financial benefit of this requirement. According to a survey conducted by McKinsey & Co., 78% of major institutional investors are willing to pay more for the shares of those companies that have good corporate governance. At that, premiums on shares offered by issuers from developing countries can be as high as 40%. This means that the quality of corporate governance becomes a serious investment criterion.
In short, the largest domestic companies that are orientated towards global markets have already reached a stage in their development where a neglect of corporate governance can weaken their competitiveness. They understand that their growing demand for capital and quality management would hardly be satisfied if their corporate governance has not been radically reformed, which is why they cannot do without independent directors.
In the sphere of state asset management, the implementation of corporate governance is the most proactive. As stated by Ulf Wokurka, deputy chair of the board of Samruk, the main task of the holding is to raise the long-term value of the assets it manages. According to Mr Wokurka, this can be attained through the improvement of corporate governance and encouragement of investment activities not only within the holding, but also in large national companies. To this end, the government has adopted a model corporate governance code for state-owned joint stock companies. To date, the subsidiaries of Samruk have established boards of directors comprising INEDs. Yet, although the effectiveness of national companies went up thanks to these measures, Mr Wokurka believes that, in these terms, they still cannot fully compete with the private sector. The reason is that, on the one hand, they are overloaded with older forms of interaction with the government and, on the other hand, they try to operate as ordinary joint stock companies orientated solely to market needs.
Marat Mominbayev, managing director for corporate governance of KazMunayGas, supports this opinion: “As a state-owned company, in some cases we cannot clearly delimit our purely commercial functions aimed to raise our value, and our tasks to advance social and economic development in the country that sometimes contravene our business objectives.” Mr Mominbayev believes that corporate governance and, primarily, independent directors will help improve this situation.
Ulf Wokurka is confident that partial placement of shares of state-owned companies on the stock market will automatically entail a qualitative improvement in their corporate governance. In such an event, the structure will include minor shareholders who will be stricter and more vigilant in overseeing that the board acts in their best interest and, consequently, in the interests of governmental shareholders. He noted that this would require dialogue with the government, since today’s definition of “strategically important assets” hinders participation in stock markets.
Today, Samruk has only two subsidiaries, the minority shareholders in which are private investors – Kazakhtelecom (49% of shares) and KazMunayGas E&P (about 40%). The latter is the only Kazakh company that has been awarded a corporate governance rating from Standard & Poor’s. As stated by Svetlana Borodina, director of S&P’s Corporate Governance Ratings, ratings are awarded after an analysis of the shareholding structure and external exposures, observance of the shareholders’ rights and relationships with persons having a financial interest, the disclosure of information and audit, as well as the structure and effectiveness of the board. This data helps investors who buy shares in stock markets to better evaluate their risks. It is noteworthy that in our country this rating was awarded to a state-owned company.
We have to admit that the government’s use of its administrative function and legislative instruments does bear fruit – at least, in the state-owned sector of the economy. Yeseb Masalin, director of KazMunayGas Consulting’s group for corporate issues, noted at the summit that, beginning from the next year, the public procurement law would be supplemented with provisions that will allow state-owned companies with a corporate governance rating to be exempt from some requirements. Currently, a draft law is being prepared which will set the rating levels and a list of agencies whose ratings will be recognised. According to Mr Masalin, these amendments can be deemed another step by the government to encourage the implementation of the best corporate governance practices in Kazakhstan. Mr Masalin also emphasised that this measure should not be considered too narrowly since the number of companies affiliated with the state is rather high in our country. In addition, to implement new large investment projects the government is now promoting a mechanism of public-private partnership, which means that, in the near future, the number of companies and joint ventures, which will benefit from this law, will grow further. Therefore, this act should not only be of interest to state holdings and their subsidiaries.
Experts agree that, save for public Kazakh corporations and state-owned companies, the majority of our businesses are barely perfunctory about complying with the principles of corporate governance. The main reason is the structure of equity or, to be more precise, its concentration. A lion’s share of medium and small companies are joint stock companies fully owned by parent holdings, or “family” companies (where shares are distributed among shareholders, but are not listed on an exchange), or various joint ventures (established as joint stock companies without minor shareholders and portfolio investors). According to Aydarkhan Kusainov, general director of Almagest, these companies tend to consider corporate governance as additional and ineffective costs. In this context, the institute of independent directors is believed to be a burden: an unwelcome but, unfortunately, compulsory requirement.
This is confirmed by a survey on implementing corporate governance in Kazakhstan that is currently being conducted by the IFC Project for Corporate Governance in Central Asia. Gennady Orekhov, deputy project manager, noted during his presentation that, as demonstrated by the survey of 120 Kazakh companies, there are three main problems in this sphere. First, in the majority of these companies INEDs have a more nominal function than directors who represent major shareholders. This is because the boards fulfil non-specific functions and intervene in operating management, which should be within the exclusive powers of the executive body. Executive members on the board usually have their own office in headquarters and are present in the company on a full-time basis. They have easier access to information, establish informal relations with the executive bodies and get advices from employees and specialists. Independent directors take part in board meetings only, usually not regularly. Board meetings are often held twice a week, which is not common in international practice. For instance, the board of HSBC, one of the largest banking structures in the world, meet only four times a year. According to the IFC survey, only 6% of domestic companies have committees established under the board and, as a rule, INEDs do not play a significant part in these committees.
The second problem is a consequence of the first one – INEDs are detached from their companies due to, primarily, limited access to information. The existing remuneration schemes do not encourage their proactive involvement in management either. In most cases, the remuneration of INEDs is lower than that of directors who represent the owner. Besides this, the sums of remuneration are fixed and do not depend on an INED’s membership of committees or taking part in meetings. Another reason for detachment is that the responsibility of the board and independent directors in particular is not clearly determined. According to Mr Orekhov, this issue is rather topical for Kazakhstan, which is why a need to deepen and detail the respective laws has emerged. To resolve these problems, the IFC recommends making contracts that would provide for the responsibility and remuneration of INEDs, and formalising relationship between the executive body and the board.
In conclusion, Mr Orekhov noted that the current law does not provide for any eligibility requirements for INEDs, although in Kazakhstan there is already a lack of qualified candidates to fill this position. As regards the requirements, this issue is partially solved by the model corporate governance code adopted by the Issuers’ Council in 2005, while the lack of human resources is made up through inviting independent directors from abroad (although this is often inconvenient and significantly more expensive). The above facts lead to the conclusion that the potential of the institute of independent directors has not been realised in Kazakhstan to date: they do not fulfil the function of independent managers and guarantors of the rights of all shareholders.
And that only applies to companies that have already included INEDs in their boards. There is nothing to say for the bulk of domestic joint stock companies.
It would be fair to say that this situation is typical of all developing economies. According to Yuri Bobyr’, vice-president of the Ukrainian Association of Independent Directors, out of 33,000 joint stock companies registered in this country only 90 have their own corporate governance codes and only 24 have been awarded corporate governance ratings. Mr Bobyr’ believes that the main reasons for this are the prevalence of sole management (at least, in medium-sized businesses) and a recommendatory nature of the Ukrainian laws on corporate governance.
Among the main barriers that hinder implementation and effectiveness of this institute, there were also mentioned legislative obstacles, an insufficient statutory base, the owners’ fear of losing control, and their unwillingness to make their businesses transparent.
The most interesting comments in this regard were made by Leonid Savinov, Moscow Interbank Currency Exchange’s (MICEX) director for listing and issuer accounts, who believes that the main reason for the unpopularity of corporate governance is the poor development of the CIS stock markets. Mr Savinov thinks that companies will agree to expand their shareholding structure only if local exchanges would arouse their interest as a real source of capital. Entering a stock market is a real trigger for a company to develop mechanisms that would demonstrate its effective management, the compliance of its corporate governance with the best practices, and the protection of the minority’s interests. In such an event, it is no matter whether the law is compulsory or recommendatory. The issue of corporate governance only became not a theoretical, but purely practical agenda when Russian companies began to massively occupy the domestic stock market and arrange Russian IPOs.
Mr Savinov also shared his idea of how to make domestic stock markets do the real job: “The main thing is to attract a huge number of players, that is to say to create a speculative exchange environment or a “liquidity pad”. No exchange market can exist otherwise. If a market is occupied solely by the state, or major banks and institutional investors, liquidity can be very high but the number of transactions will be too small and issuers will be of no need”. To this end, individual investors or, in other words, the population should be attracted. In this field, Russia is several years ahead of its CIS neighbours. Leonid Savinov thinks that, in addition to the programmes to promote the investment literacy of the population, a great contribution was made by MICEX when it launched its technical floor which allowed any citizen of Russia to feel the trading environment from their home, with the help of the Internet. The population was offered a technical opportunity to take part in real trading. Today, MICEX has 465,000 registered individuals who are, in fact, professionals making their own trading decisions. An extra 500,000 are clients of asset management companies. Mr Savinov estimates that in ten years 10 to 15 million people will play in the domestic stock market.
One would not disagree that this is a good issue for Kazakh traders to ponder.
A Figurehead or a Key Player?
In any case, all Kazakh joint stock companies, without any exception, will need to comply with the statutory requirements. The only question is what role will be assigned to independent directors, i.e. whether they will become a real instrument of management or a mere cipher. What if a company does not plan to go public, but needs to comply with the rules? Mr Kusainov believes that the institute of INEDs is in itself a perfect instrument to raise the efficiency of a business. An independent director can have various functions, including representative ones. Now, this position becomes increasingly important from the point of view of the companies’ management, owners and major shareholders. An independent director can be very useful for them as an internal adviser or strategist. It is no secret that domestic businesses continuously lack talented employees. Involving such people as INEDs (part-time employment, status and remuneration) offers serious advantages. At the same time, toughening competition and dynamics of the market call for a continuous analysis of the company’s strategy from an outside perspective. Technological and communication innovations make it possible to hire the best experts to do this job, since the position of an INED is not a daily employment. It is clear that world-class specialists cost too much, but if they are employed as independent directors this may be a serious saving. It is also important that, as distinct from external business advisers, INEDs are officials and are responsible for the decisions they propose. Thus, a carefully selected independent director can become a real success factor for any company irrespective of its patterns of ownership.
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