It is critical to define the criteria for independent directors and implement this strictly in the interests of good governance; otherwise we could be in for a ‘blind date’ with yet another crisis

Consider the following occurrences that happened in some NBFC MFIs.

The first instance is an email conversation between two members of the board at a large NBFC microfinance institution. The mail was supposedly received on Wednesday, 23 September 2009.
> "I noticed something in the AGM notice that I had not seen before and specifically raised it to person YYY. The agenda item is a supposed discussion on a NNN year contract for ZZZ person (to be filed with GoI for concurrence) and that this was approved by the compensation committee, on which I also happen to sit. I spoke with CCC and BBB, both of whom are members of the same committee with regard to this and they have absolutely no recollection of such a proposal. Hence, I have asked for some clarification on this and I also thought that I should also keep you posted of the various happenings.ⁱ

The second instance concerns a large NBFC and its ESPS (employees stock purchase scheme) agreements with employees. This event apparently occurred in September 2009.
> The last page in the ESPS agreement with several employees was supposedly changed because the auditors suddenly noticed (in September 2009) that payments from employees were due by end March 2009 and had not been deducted and/or collected. However, because they did not notice it until September 2009 (when they would have had to list it as an overdue), the last page of several such agreements was supposedly changed to reflect a new (future) due date for repayment of the ESPS loans owed (to the trust) by the various employees. This enabled the ESPS loans to be not shown as an overdue. Now, I have the concerned documents but have refrained from naming the MFI because my intention is not to report on any single case-rather, I want to use this example to illustrate the kind of governance that occurs at many MFIs.

The third event relates to a connected lending transaction where the NBFC MFI lent its founder managing director a sum of Rs 1.636 crore to enable him to buy shares at par in the same company (Professor MS Sriram's paper in Economic and Political Weekly, 12 June 2010).

And there are many more similar instances, but the idea is not to provide a long list of such happenings to tarnish the image of concerned MFIs. Rather, it is to merely demonstrate the kind of not-so-good governance practices prevalent at some of India's largest (NBFC) MFIs and strongly drive home the point that we need more stricter and precise laws regarding definition of independent directors. Otherwise, the NBFCs (MFIs included) will simply get away by perhaps appointing all and sundry and "yes" men/women to the board - and then governance will sadly falter, despite the presence of even so-called institutional directors.

For example, the nominee director of a large financial institution kept quiet when some of the above instances happened, perhaps because of serious conflicts of interest, such as the likely loss of an MFI client/market for their loan funds, if they were to speak out.

All of this makes the role of independent directors very crucial and therefore, the determination of who is an independent director and who should be treated as an independent director becomes very important. Two key questions arise here: (a) How to make this determination of a director's independence; and (b) What objective criteria can be effectively used in microfinance in India and especially for unlisted companies (NBFCs) involved in financial intermediation. I offer some suggestions here and these can be used by the Reserve Bank of India (RBI) and the Union Ministry of Finance (MoF) as part of their current efforts in framing the regulatory (including corporate governance) guidelines for the crisis-ridden Indian microfinance industry.

Firstly, for an MFI director to be considered independent, it must be conclusively and affirmatively determined that the director has no materialⁱⁱ relationship (whether financial, business, personal or otherwise) with the MFI, or any of its sister concerns or subsidiaries or affiliates or group entities, either directly or as a partner, shareholder or officer or employee of an institution, which in turn has a relationship with them. This is very critical.

Further, in making the determination of independence, a director's relationships can be deemed immaterial as long as the following standards are met:
(a) Director's relationships: The director is not, and has not been within the previous three years, an employee of the MFI or any of its subsidiaries or affiliates or sister concerns or any other group institution.
(b) Relationships of the director's immediate familyⁱⁱⁱ No member of the director's immediate family  is/has been, within the previous three years, an executive officer of the MFI or any of its subsidiaries, or affiliates, or sister concerns, or any other group institution.
(c) Compensation of director/family members: Neither the director nor any member of his or her immediate family has received, during any 12-month period, within the previous three years, significant^iv direct compensation from the MFI, or any of its sister concerns, or subsidiaries, or affiliates, or group institutions (including without limitation, any consulting, advisory or other compensatory fees) except (1) fees which the MFI pays to its directors for their services as members of the board, and members or chairs of board committees, and (2) fixed amounts of deferred compensation for prior service, which is not contingent in any way on continued service; provided that compensation paid to an immediate family member for service as an employee other than an executive officer will not be considered in determining the director's independence, so long as the compensation is comparable to the compensation paid to other similarly situated employees.
(d) Director's/family members' relationship with MFI auditors: The director is not a partner or an employee with a firm that is the internal or external auditor for the MFI, or any of its sister concerns or subsidiaries or affiliates or group institutions; nor is any member of the director's immediate family a partner with such a firm or an employee who participates in the firm's audit and/or tax compliance practice (as well as similar tasks); nor has the director or any member of the director's immediate family, within the previous three year's been a partner or employee with such a firm that has, within that time, personally worked on the audit of an MFI or any of its sister concerns or subsidiaries or affiliates or group institutions. {break}
(e) Compensation committee aspects for director/family members: Neither the director, nor any member of his or her immediate family is employed, or has been employed, within the previous three years, as an executive officer of any company whose compensation committee, at the same time, included an individual who currently serves as an executive officer of an MFI or any of its sister concerns or subsidiaries or affiliates or group institutions.
(f) Director/family members' relationships with MFI service providers: The director is not an employee, nor is any member of his/her immediate family an executive officer of another company where payments by the MFI to that company or from that company to the MFI, including their respective subsidiaries and affiliates or sister concerns, for property or services, have exceeded more than 2% of the other company's consolidated gross revenues in any of the other company's past three fiscal years.

However, notwithstanding anything to the contrary in standards #a through #e above, any MFI shall not treat as categorically immaterial, but instead will discuss case by case and will disclose (i) any relationship between a director and the MFI or any of its sister concerns or subsidiaries or affiliates (or group institutions) that is required to be disclosed under the relevant section of the Indian Companies Act, 1956 (and other SEBI/RBI directives from time to time) and (ii) any contributions made by the MFI or any of its sister concerns or subsidiaries or affiliates to any tax-exempt organisation of which a director serves as an executive officer if, within the preceding three years, such contributions in any single fiscal year exceeded 2% of the tax-exempt organisation's consolidated gross revenues.

You may wonder why I have dwelt so much on the topic of independent directors. One of the most critical reasons for the importance attached to the topic of independent directors in any organisation (including MFIs) relates to conflicts of interest. There are several issues here: (1) Conflicts of interest hinder judgement and affect decision-making. (2) Judgement and decision-making are what directors are asked to do. And (3) directors must feel free to think, express, question and decide in the interest of those they represent.

And all of these apply very much to microfinance institutions as well who, during the last year or so, have received a lot of (negative) publicity with regard to corporate governance^v conflicts of interest and the role of independent directors on their boards. In fact, the debate has widened to encompass not only the roles of independent directors, but also that of nominee directors from financial institutions, and several questions continue to be raised regarding real and potential conflicts of interest on the ground.

Some of the key issues that the microfinance industry continues to grapple with are: (a) Does a board need to have clear guidelines with regard to conflicts of interest that must be disclosed? (b) Who discloses conflicts? (c) To whom are conflicts disclosed? (d) What happens if conflicts are not disclosed? (e) What if conflicts are disclosed later? (f) What if all is not disclosed to the board and/or to shareholders?

Without question, the above issues need to be addressed fair and square, and there can be no compromise with regard to that. Therefore, unless and until the RBI and the Union Ministry of Finance specifically address the issue of precisely defining independent directors with regard to microfinance and especially non-listed systemically important NBFC MFIs, we will continue to see colleagues, friends, associates and relatives functioning as independent directors (with huge conflicts of interest) and good corporate governance will remain an elusive dream. And if that happens, we could be making a 'blind date' with the next microfinance crisis (as the well-intentioned regulations will not be implemented on the ground) and responsible microfinance will continue to remain an illusion indeed!

ⁱ Names have been withheld as the idea is not to embarrass any individual MFI; but the original email can be provided if required!
ⁱⁱMateriality" is to be considered from the standpoint of the director and that of each person or organisation with which the director is affiliated, including organisations of which the director is a partner, shareholder or officer. The determination that, as to each director individually, there is no material relationship (whether financial, business, personal or otherwise) will have to be made after due consideration of the information provided by the director and any other information that may be known to the board. The purpose is ultimately to determine whether a director has any relationship with the MFI that may interfere with the exercise of the director's independence with regard to the MFI and its management.
ⁱⁱⁱImmediate family" means a director's spouse, parents, stepparents, children, stepchildren, siblings, mothers- and fathers-in-law, sons- and daughters-in-law, brothers- and sisters-in-law, and any person (other than a tenant or employee) who comprise the director's household, but not the physical space necessarily.
^iv This has to be debated and decided accordingly, as per consensus. The RBI and Ministry of Finance would have to take initiative in this regard.