Evaluating The Regulatory Framework Governing Executive Compensation In Listed Companies

Evaluating The Regulatory Framework Governing Executive Compensation In Listed Companies

The process of determining executive compensation in listed companies consists of three stages: the Nomination and Remuneration Committee (“NRC”), the Board of Directors (“Board”), and the shareholders. In the first stage, the NRC identifies specific candidates for the position of directors, formulates a remuneration policy for the proposed directors, and submits these recommendations to the Board for approval. In the next stage, after receiving recommendations from the NRC, the Board reviews them and makes decisions regarding the appointment and remuneration of directors. In the final stage, the NRC’s recommendations as approved by the Board are submitted to the shareholders for a vote. Theoretically, shareholders have the final say in determining executive compensation. However, the regulatory framework governing executive compensation in India, while seemingly robust, presents certain ambiguities and loopholes that could potentially compromise its effectiveness.

This note delves into the key issues surrounding the determination of executive compensation, focusing on the roles of the NRC, the Board, and the shareholders. It analyzes the existing regulations under the Companies Act, 2013, the Securities Exchange Board of India (Listing Obligations and Disclosure Requirements) Regulations, 2015 (“Listing Regulations”), and the Secretarial Standards, highlighting critical areas of concern and proposing potential solutions to strengthen the framework.

PROMOTER DIRECTORS ON THE NOMINATION AND REMUNERATION COMMITTEE

Regulation 19 of the Listing Regulations stipulates that the NRC must be composed of non-executive directors. The NRC must consist of at least three directors, two-thirds of whom must be independent, with an independent director serving as the chairperson of the committee. The Chairperson of the listed entity, whether executive or non-executive, may be appointed as a member of the NRC but may not chair it. While this structure aims to ensure independent oversight, a critical issue arises when a promoter director is designated as 'Non-Executive'. This designation enables their appointment to the NRC without violating existing regulations. However, such an appointment could potentially grant the promoter director significant influence over the NRC's functioning, including the appointment and remuneration of other directors. While this may not generally be problematic, since the interests of promoters are generally aligned with those of the listed company, conflicts of interest will undoubtedly arise if a proposed appointee is related to the promoter. The absence of a legal requirement to notify stock exchanges of NRC meeting resolutions further exacerbates this issue, contributing to the opacity of the process. Additionally, there is ambiguity as to whether a non-executive promoter director may be involved in recommending the appointment and terms of another director related to such non-executive promoter director.

To address this concern, two potential solutions emerge. The first involves amending the Listing Regulations to permit only independent directors on the NRCs of listed entities. This would eliminate the possibility of promoter influence altogether. However, recognizing the potential need for representation of institutional investors, an alternative solution proposes prohibiting any promoter director from being a member of the NRC. This approach balances the need for independent oversight with the practicalities of board composition.

LACK OF TRANSPARENCY IN BOARD PROCEDURES

The process of determining executive compensation involves the NRC identifying and recommending candidates and their remuneration under Section 178 of the Companies Act and Schedule II of the Listing Regulations. This is followed by Board approval of the terms of appointment and remuneration of directors, as mandated by Section 196(4) of the Companies Act.

Regulation 30 of the Listing Regulations mandates the disclosure of material events or information by listed entities in the event of a change in directors. The following disclosures are required to be made to the stock exchanges within 30 minutes from the closure of the Board meeting:

1. The reason for the change (e.g., appointment, re-appointment, resignation, removal, death or otherwise);

2. The date of appointment / re-appointment / cessation (as applicable) and the term of appointment / re-appointment;

3. A brief profile (in the case of an appointment); and

4. Disclosure of relationships between directors (in case of appointment of a director)

However, Regulation 30 does not require disclosure of the NRC's recommendations to the Board, nor does it require the Board to confirm whether it has acted in accordance with the NRC’s recommendations. This lack of transparency creates a significant gap, as shareholders remain unaware of any substantial deviations from the NRC's recommendations.

The solution lies in enhancing disclosure requirements. Regulation 30 should be amended to mandate the disclosure of whether the Board acted in accordance with the NRC's recommendations, along with the nature, extent, and reasons for any deviations. This would provide shareholders with crucial insights into the decision-making process, promoting accountability and informed decision-making.

LIMITED DISCLOSURES TO SHAREHOLDERS

Prior to the general meeting at which the resolution for the appointment of a director is to be considered, the company is required to provide shareholders with information regarding the terms and conditions of the remuneration payable to the Directors, as mandated by Section 196(4) of the Companies Act.

Under Regulation 36(3) of the Listing Regulations, in the case of appointment or re-appointment of a director, shareholders must be provided with a brief resume of the director, their expertise, relationships with other directors, directorships, and committee memberships (including recent resignations). Further, Schedule V of the Companies Act requires companies with inadequate profits to make certain additional disclosures as part of the explanatory statement to shareholders including past remuneration, a comparative remuneration profile with respect to the industry, the size of the company and the profile of the position and the person.

While these provisions mandate certain disclosures regarding director appointments and remuneration, the scope of these disclosures is often limited, and there is no standardized format. As a result, there is significant variance in the way different listed companies disclose the terms of appointment, particularly the remuneration payable to proposed directors. This inconsistency hinders shareholders' ability to make informed decisions, as they lack a comprehensive and comparable view of executive compensation practices across companies. Furthermore, the additional disclosures required for companies with inadequate profits, such as past remuneration and comparative remuneration profiles, are not uniformly applied.

To address this, SEBI should prescribe a standardized format for mandatory disclosures to shareholders. This format should encompass all relevant information, including past remuneration, comparative remuneration profiles, and any pecuniary relationships with the company, regardless of the company’s profitability. Standardizing these disclosures would empower shareholders with the necessary information to evaluate executive compensation packages effectively.

PROMOTERS APPROVING REMUNERATION OF PROMOTER DIRECTORS

Regulation 23 of the Listing Regulations provides procedural safeguards for related party transactions. Additional safeguards are outlined for material related party transactions, including requirements for Audit Committee approval and a special resolution of the shareholders. Moreover, Regulation 17(6)(e) of the Listing Regulations requires that, in the case of fees or compensation payable to executive directors who are promoters or members of the promoter group, shareholder approval by special resolution is necessary.

While Regulation 23 of the Listing Regulations provides safeguards for related party transactions, the appointment and remuneration of promoter directors fall outside its purview. This exclusion allows promoters to vote on their own remuneration, potentially leading to outcomes that favor them at the expense of minority shareholders. This issue is further compounded by the practice of shareholder voting based on shareholders entitled and voting (i.e., votes cast) rather than shareholders by value (i.e., votes eligible to be cast), combined with generally low public shareholder turnout and high promoter shareholdings. This combination of factors effectively grants promoters significant control over the approval of their own remuneration.

Two potential solutions are proposed to mitigate this risk. The first solution requires the approval of the majority of minority shareholders for resolutions involving the appointment and remuneration of promoter directors, ensuring that such decisions are not solely driven by promoter interests. Alternatively, splitting the resolutions for nomination and remuneration, and prohibiting promoters from voting on the latter, provides another avenue to safeguard shareholder interests. This approach directly addresses the conflict of interest inherent in promoters voting on their own compensation.

CONCLUSION: STRENGTHENING THE FRAMEWORK

The existing regulatory framework for executive compensation in India offers a foundational structure but is hindered by several critical shortcomings. Key issues include the potential for promoter influence over the NRC, a lack of transparency in Board processes, insufficient disclosures to shareholders, and the ability of promoters to approve their own remuneration. These factors collectively undermine the fairness and effectiveness of the system.

To address these challenges, the proposed reforms – such as bolstering the independence of the NRC, increasing transparency in Board decisions, expanding and standardizing shareholders disclosures, and implementing safeguards to prevent self-dealing in promoter remuneration – can help establish a stronger and more equitable framework for executive compensation. These changes will not only safeguard shareholder interests but also promote enhanced transparency, build trust, and improve confidence in the corporate governance practices of listed companies.