By Mandar Kagade, Analyst, Bharti Institute of Public Policy, ISB
This article was first published in Moneycontrol.com on March 25, 2014
In a recently held Board meeting, the Securities & Exchange Board of India (“SEBI”) has decided to amend the Listing Agreement and disallow public listed companies from remunerating their Independent Directors using stock options. This move is catalyzed by the intent “to make the provisions of the Listing Agreement aligned with the provisions of the newly enacted companies Act, 2013”.[1] In 2013, the country gave itself a new Companies’ Act, 2013 (“Act”) that brought in some very significant changes including in the regulation of Independent Directors. The Act prescribed their rights and obligations, the nature of remuneration they would receive and so forth. Most notably, the Act has proscribed companies from paying their Independent Directors in stock options.[2] This was a myopic and regressive step, as we will discuss in the following paragraphs; but one had hoped that the capital market regulator, SEBI at least would continue the status quo for listed companies and advocate the use of stock options for them, where they have been most effectively (and where their use is more justified as well); as things turned out, that was not to be.
The sum total of these two regulatory measures is that all companies will now remunerate their Independent Directors in fees, profit-linked commission (as approved by members) or in stock. But that misses out on appreciating the powerful role incentives play, in regulating human behavior. Directors (and managers) of companies have their human capital locked in their companies. These constituencies therefore have an incentive on the margin to be risk-averse. On the other hand, the shareholders are diversified and therefore care little about the unsystematic (company-specific) risk flowing from a company per se. Their incentives are therefore to see that individual companies pursue valuable though uncertain investment opportunities. Now, imagine an Independent Director remunerated in cash; she will be paid regardless of whether she is vigilant about monitoring the “insiders.” Accordingly, it is natural to visualize the Independent Director going through the motions of attending board meetings and then collecting her fees at the end of her routine. Since her actions in the board meetings are de-linked from her wealth and the stock holders, it is easy to infer that the Independent Director remunerated exclusively in cash would be a bad monitor of shareholder interests. Similarly, compensating management and the Independent Directors in stock will merely make more of their wealth tied up to the Company’s (unsystematic) risk and misalign their incentives from the outside shareholders by making them risk-averse as more of their personal wealth is tied up with that of the company.
Stock options provide the solution to precisely this dilemma because they have no downside and an unlimited upside potential. The asymmetric nature of their payoff structure essentially ensures that Independent Directors have incentives to see that the management of the Company invests the company’s assets in valuable but uncertain projects than they would otherwise, thus creating shareholder value.[3] Little wonder then, as Yermack notes, tying directors’ pay more closely to stock performance through use of options and other equity awards has been a frequent goal of shareholder initiatives in the United States of America.[4]
Other remunerative instruments that the Act permits are profit-linked commissions. Because they are linked to profits, commissions based on profits arguably align the incentives of Independent Directors and the shareholders. But they are an inefficient alignment device as commissions based merely on profits are likely to promote short-termism. This is in as much as profits fail to capture the value of future growth opportunities of the company thus disincentivizing the Independent Director to think for the long term. Furthermore, profit-linked commissions cannot be structured to payout in a staggered fashion without sacrificing the incentive alignment.[5] On the other hand, stock options are linked to stock price that impounds the value of future growth opportunities thus promoting the Independent Director to think long term. Also, stock option plans can be designed so as to vest in a staggered fashion thus incentivizing Independent Director to act in the interests of shareholders in the long term.
Unfortunately, the regulators in India have espoused the very instruments that increase incentive-incompatibility between Directors and their shareholders. It is high time regulators move away from their fixation of cash and permit alignment between shareholders and Independent Directors through market mechanisms.
[1] See Press Release PR 12/2014, SEBI Board Meeting.
[2] See Section 149 (6) of the Act.
[3] See David Yermack, Remuneration, Retention and Reputation Incentives for Outside Directors, p. 12, 36 (2003) (finding statistically significant association between the pay-performance sensitivity and growth opportunities of the firm measured in terms of Tobin’ Q and R & D/ assets) available at, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=329544&download=yes. See Michael Jensen & Kevin Murphy, Performance Pay and Top Management Incentives 98 (2) Journal of Political Economy p. 227 (defining pay-performance sensitivity as a dollar change in CEO wealth per dollar change in shareholder wealth).
[4] Supra note 3 at, p.3
[5] This is because, if the commission payout is deferred over a period of time, the opportunity cost incurred by the Independent Director on that payout will decrease the incentive effects linked to such commissions.
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“The views expressed in this article are personal. Mandar Kagade is Policy Analyst at the Indian School of Business.”