On the issue of board directors, the SECP may need to go back to the drawing board

The election of directors is a problematic issue but SECP is not seeing the real issue at hand

By Zain Naeem

What does the member of a board of directors do exactly? In publicly listed companies they have many functions, and they also come in all kinds of flavours. But predominantly the position of director on the board of a company is clinched by the power of nepotism. 

About 60-70% of the people appointed as directors to the vast array of publicly listed companies in Pakistan are family members of the companies’ majority shareholders, estimates Safdar A Butt, an academic with years of business experience who is currently a Professor Emeritus of Finance and Corporate Governance at the Capital University of Science and Technology in Islamabad.

This is a bit of a problem. You see a director in a company is someone elected or appointed to manage a company’s business and affairs. Every registered company must have at least one director, and most large companies are run by a board of directors which votes on important matters such as the appointment of a CEO. And since publicly listed companies are owned by different shareholders, a company’s board of directors should ideally represent this ownership pattern. 

In Pakistan, however, there is a bit of a problem. Because most directors are either relatives or the employees of owners, there is rarely much representation on boards for minority shareholders. On top of this, there is often a conspicuous absence of women and independent directors on these boards. 

To this end, the Securities and Exchange Commission of Pakistan (SECP) has claimed they are making an active effort to bring local practices inline with international standards when it comes to boardrooms of corporate Pakistan. The Company Act of 2017 made strides in setting laws for a largely unregulated area of the market, and 2019 saw the Listed Companies (Code of Corporate Governance) Regulations being introduced. 

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The question is, have these regulations proven to be effective? Or is the SECP fighting a losing battle by window dressing rather than addressing the real problem? 

The days of company men

It was long understood in Pakistan’s corporate landscape that owners get to appoint directors of their choice. After all, as the majority owners, should the company’s major sponsor get to do as they please? Even if that means appointing younger brothers and son-in-laws with nothing better to do. Now, up until the early 1970s it was practically a free for all. This meant whoever was managing the company’s affairs could unilaterally appoint anyone of their choice to the board. 

This practice was put to an end by the Companies (Managing Agency and Election of Directors) Order of 1972. The order eliminated the earlier practice and mandated that the companies should carry out elections in order to make the process more democratic.

The order was still very much in favour of the major sponsors, but it was the first step towards a more democratised process of electing directors. This was further crystallised in the Companies Ordinance of 1984 which formalised the appointment and removal of directors through due process. 

For quite some time this was really the only significant legislation regulating how companies in the public sphere were governed. And for the most part it meant that while directors had to be elected and a certain process beyond just a word and an office memo with the CEO’s signature followed to appoint or remove one, things were pretty much as you’d expect. 

The problem was that these directors treated their job as a family or company appointment because that is what it was for them. “Most of the directors we have don’t know how to do the job” says Professor Butt. “For some reason there seems to be no realisation that as the director of a company, they have obligations towards all stakeholders, and not just their family or friends that gave them the position.” And that is also where the problem exists. 

“Ethics and the law are not always on the same page” says Butt. “You, as a director, may think you’re doing something moral or just, and in your own mind, you will be completely justified. “But it is entirely possible that you may just be breaking the law in the process. Say you are a director and you think three of your four managers deserve bigger bonuses than the fourth one. Now you may think this is fine, but unless there is some definable criteria for giving bonuses, this is criminal behaviour – no matter your intentions.”

Changing times

It was perhaps this litany of problems that led to the introduction of the Company Act of 2017 which replaced the 1984 ordinance. Even though changes were made to the laws governing companies, the election of directors was mostly left untouched. Many of the powers given to directors were left unperturbed which points to the resilience of the laws made 35 years earlier.

The SECP was essentially facing the heat because Pakistan lagged far behind compared to international standards. Because of this, through this new act, the SECP was encouraging companies to move towards independent directors. It asked companies to voluntarily put independent directors up for election with a focus on female representation.

To formalise this process, Listed Companies (Code of Corporate Governance) Regulations were brought in 2019 which focused on Corporate Governance. Language was added into the regulation to make it mandatory for companies to be made part of a Board of Public Interest Companies (PICs).

PICs, as defined by SECP, are listed and non-listed companies which are operating in the public sector, involved in essential public service or involved in the holding assets in the fiduciary capacity like a bank or insurance company. It also includes non-listed companies which have public shareholders.

In essence, these laws are meant to bring in a change in the corporate governance of the companies. By including independent directors and having female representatives on the board, the company gets to gain from the experience and the skills of the independent directors which the company would not have access to previously. 

“The amendments or changes that were introduced in the (Companies) Act regarding female and independent directors have ensured diversity and women’s inclusion and led towards a more robust corporate governance regime,” a representative of the SECP tells Profit. 

In the olden days, the board of directors were seen as a formality rather than a necessity and directors were put into place as a way to appease regulators. Now it can be seen that having access to a broader pool of skills and abilities is beneficial for the company as well. 

Having different perspectives and experiences in the board of directors allows for better problem solving and brings new solutions to the table that might not be considered. What really is the role of the board of directors and how are they important?

Why seats on the board matter 

Let’s dust off our old finance textbooks and see why the board of directors are important. It is called the agency problem and conflict of interest. Come on, say it with me. You all know it. The agency problem is that shareholders and managers are at odds with one another as the shareholders actually own the company, however, they do not have the expertise to run a company. Good job everyone. 

When corporations get too large, the interests of shareholders and managers can diverge. It is in the interest of the shareholders for the company to do well and make them money. The interest of the managers is to run the company which yields the highest amount of vertical mobility and benefits for them.

As the interests begin to differ, the best solution is to place a board of directors in the middle. The board of directors act as a bridge which is able to connect the management and the owners of the company together. The board is able to communicate the needs and interests of the shareholders to the management and holds them accountable.

The board of directors is elected by the shareholders and is involved in many of the key decision making for the company which have to be implemented by the management. This delegation of authority means that they act on behalf of the owners. 

From the appointment of the executives of the company to their salaries and benefits and major decision making power, the board gives approval before any significant decision is made. They give this approval after they get the nod from the shareholders at general meetings that are held for the benefit of the shareholders. Shareholders get to vote on these issues which are then carried out by the board. 

This aligns the goals of the management with the goals of the shareholders. This board is also given powers to create governing documents and put policies in place which the management has to abide by. In essence, they have a supervisory function over the management and they can review the performance of the officers under their purview. 

Why you need independents on the board 

In such a case, qualified and independent directors become important. Qualified directors are people who actually know the ins-and-outs of the industry or the field the company is involved in. This allows them to provide key insight into its operations. Similarly, independent directors are people who are not related to the company at present or in the past at any point and are coming from outside the company. They see problems being faced by the company with a fresh pair of eyes.

When both of these attributes are combined, the company has a board of directors who are able to understand the company and are able to guide them in a better direction without having any conflict of interest. They are not related to the company and have the skills to critique and improve its performance in the future. 

A balance needs to be struck between executive directors, who are part of the current management of the company and have a view from outside the company to provide a new perspective. Lastly, female representation, in a society like ours, can also provide vital insights for the company going forward. Uptil now, SECP is coming off in the clear with great intention and plan. Wait a little bit and see how they muddle this up.

The process of election

To understand the real issue that plagues the companies is to get to know how the election is actually carried out. The election of directors is carried out for 3 years after which they are seen as being retired and have to be reelected. Companies can carry out elections in a staggered manner and carry out elections for only the retiring directors, however, most companies have elections for all the seats of its directors.

In its initial meetings, the board has to decide the number of members who will be a part of it. This number can be changed later by the board at a meeting as well. Let’s assume there is a company called “Kakkar International Limited”, there are seven directors who are going to be elected.

Candidates have to show interest in taking part in the election and have to submit their documents with the company secretary. The company secretary can scrutinise these documents based on the laws and regulations of the SECP and the company itself and then declare the eligibility of the candidates for the election.

In our example, there are seven seats and let’s say that seven people show interest to be elected. In that case, all the candidates become directors, the world is perfect and serendipity rules the land.

In case eight people are interested in competing in the elections, an election actually does take place on a cumulative basis. This means that each shareholder gets the number of votes equal to his shareholding multiplied by the number of director seats to be filled.

Kakkar International Limited has 100 shares that it has given out to its shareholders. This means that a total of 700 votes will be cast. Every shareholder gets a ballot paper and can vote for as many candidates he likes with his seven votes. Even voting for a single candidate multiple times.

Once the results are tabulated, the candidate receiving the most votes becomes a director. The next highest voted receiver gets to be the second director. This process continues until all the seven directors are chosen and one candidate loses.

The implications of such an election

The implications of such an election are that, even though the majority shareholder has the most shares, still the minority can band together and combine their votes to vote for a director that they like. In the example that was given, let us suppose that 55% is owned by the sponsors while 45% votes are held by the minority or shareholders outside the company.

In such a case, out of the 700 votes, 385 votes are with the sponsor while the remaining 315 are with the other side. If there are 8 candidates, the most votes needed to pass the threshold will be around 88 votes. If all the directors get 88 votes each, the last one will get 84 votes and will not be elected.
This was the methodology that was followed till now which meant that minority shareholders could put up as many of their own candidates up for elections against the majority shareholders. This allowed them to have a voice and have a counterbalance against the majority getting its way.

The flaws of the laws

In such a scenario, the laws were being abused by the majority shareholders. They would look to corner the shareholding by asking for shareholders to hand over their proxies to the sponsors. Proxies are privileges that are given by a shareholder to someone else who can act on behalf of the shareholder. It allows them to take part in elections and general meetings and they can vote with a bigger share of the vote than they actually own.

In addition to that, the SECP felt that as there was a tussle of control between the two sides, the spirit of the law was not being followed. Shareholders were not interested in getting an independent director or a female director on the board of the companies which was going against their efforts.

In defence of SECP itself, it states that “the laws or amendments therein are always implemented with a view to improving the corporate sector in Pakistan and promoting investor confidence.The laws implemented have brought more transparency, ease of doing business, and investor confidence.” 

“However, making legislation is a continuous, evolving process that considers changing market dynamics, international trends, and ground realities. SECP follows a consultative process to cater to the viewpoints of stakeholders and stay abreast of relevant developments.”

SECP fixes what’s not broken

In order to address these issues, the SECP looked to codify the elections in the Listed Companies (Code of Corporate Governance) Regulations 2019. In these regulations, they mandated that at least one seat was to be kept for female directors while at least 2 or a third of the board was to be made up of independent directors. This was a way for the regulator to tip the scales in favor of female and independent directors.

“The database has made it easier…to identify a pool of candidates for the election of independent directors. The database contains various details about the candidates listed therein, including their education, qualifications and job experience, etc.” states the SECP which has been aided by the database.

Directors who had been trained in relation to the program could be selected and then elected as directors of the company. This strengthened the integrity and the ability of the directors who had been trained under this framework and could provide companies with a source of directors from which to choose from.

It had been felt by the regulator that companies were having difficulty complying with the mandatory requirements of the Regulations regarding the appointment of female and independent directors as the candidates did not get a sufficient number of votes to be elected to the board.

The problem is made worse

Recently, the SECP has presented another solution to the voting procedure under SRO 906(1)/2023 dated July 7th, 2023. This ordinance acts as being “ultra vires” the specific provisions of Section 159 and 166 of the Companies Act 2017.  

They have looked to introduce a separate voting system for election of females, independent and other directors at a company. This has been done under Regulation 7A of the Listed Companies (Code of Corporate Governance) Regulations 2019 where it is mandatory to vote for the three categories of directors i.e. female, independent and other directors separately. 

This move should have been a step in the right direction. Technical experts brought to light the fact that the SECP was further weakening the position of the smaller shareholders. In the example we used earlier, if one of the directors has to be mandated as being female, the elections will virtually be held between two candidates. One would be nominated by the majority while the other would be put up by the minority shareholders. As it is a head-to-head election between two directors, the majority candidate will always win.

Going back to our earlier example of Kakkar International that we had chosen, in that scenario there are 9 directors up for election now and there are a total of 7 seats. One seat has been reserved for female directors where both sides put up their candidates. The winning candidate, from the majority, gets 55 votes while the other candidate gets 45 votes. Now there are 7 candidates left and the votes have decreased to 600 with 330 votes held by majority and 270 by minority. The threshold in the new case is 86 votes. The candidates need to get 86 votes to be elected.

The minority shareholders have barely enough votes to elect three members as they need 258 votes and even a small proxy war can mean that the minority shareholders will not even be able to place the 3 directors that are technically their right.   

What is the solution?

This issue is complex in its nature as the situation that exists is problematic. On one hand, majority shareholders hold onto a majority of the shares to make sure their decisions are imposed in the company as the sponsors feel that they funded the company and have a divine right to make its decisions. This is the reason why they keep more than 50% of the ownership of the company. 

On the other hand, are the shareholders who have invested in the company and feel that their concerns and voices need to be heard as well. The smaller shareholders have invested their hard earned money into the company and deserve some representation in the board.

Currently, the idiom of one share one vote is held true which treats every shareholder as equal. Every shareholder gets to vote in the election and get to have their say in the matters of the company. Whenever elections take place, both majority and minority shareholders come together and get to vote on the matters of the company. 

Negating a vote of the majority shareholder for the benefit of the minority shareholder will defeat the purpose of voting and might even eskew the balance of power towards the minority shareholders where they get to have an equal voice as the majority shareholders.

A better solution in this case can be setting up a threshold for election of directors. Every shareholder gets one vote and can vote yes or no for a director. It’s a straight yes or no question for each candidate up for election. In case a director has to be elected, he has to receive a certain threshold above the voting power of the majority shareholder alone. For example, the majority shareholder has 55% of the shares while the minority holds 45% of the voting power. The winning candidate must get 60% of the total votes or a percentage above of sponsors shareholding power. 

This would make sure that the will of the minority shareholders is considered and they need to go along with the decision of the majority for a director to be elected. This model will not give veto or filibuster power to the smaller side while mandating that the majority side needs support from the minority shareholders before imposing their decision.

A note to the regulator

The issue that needs to be considered by the SECP is not the fact that female and independent directors are not being nominated. Uptil now, every solution that has been presented by the SECP has looked to make the situation better. However, each and every move has fallen prey to the fact that the letter of the law is being followed while the spirit of the law is being defeated. 

It is true that the corporate landscape of the country has evolved a great deal. From having sponsors appointing directors of their choice, now at least shareholders are getting to have a say through elections. Even today, female directors are put in place who are related to the executives or management of the company and their representation is used as a cosmetic tool to show the inclusion of women in the affairs of the company. 

The corporate sector can do much better. By opening up their doors to qualified female and independent directors, the company can benefit with the experience and skills of these directors which might be lacking within the company. Within Pakistan, most public listed companies are held by the sponsors which means the rights of the minority shareholders are neglected. In a country like India, sponsors are not allowed to hold more than 25% of their own companies which means the majority does not have the capturing of the board like it does in Pakistan.

When asked regarding this, the SECP stated that “the amendments to the Regulations were made with the view that companies can now ensure compliance with the mandatory requirements of the Regulations for the appointment of independent and female directors as well as the protection of the rights of minority shareholders, which may also enable them to have their candidate on the board. The shareholders can allocate and cast their vote in a particular category without the fear of diluting their voting power in other categories. Further, it is the responsibility of all shareholders to play their part in the election of independent directors.”

Even though this can be considered a manner to allow companies to comply with the regulations, the spirit of the laws and the regulations are still not being implemented. The core of the issue is not that diversity is not being made part of the board, however, the fact is that majority shareholders are using their power to make sure their people get on the board. This is being done while little care and attention is being given to equip the company with a diverse and well qualified board. Such a board will allow the company to perform better and should represent all the shareholders of the company rather than just the majority.



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