A tricky issue of governance

What happens to Esops issued to nominee directors of financial institutions? This issue has come to the fore following Esops given by engineering giant L & T to nominee directors of GIC and LIC, both government-owned financial institutions. The nominees proceeded to exercise the options. GIC's nominee had options worth Rs 35 mn. LIC's nominee had options worth Rs 45 mn.

When the institutions got to know about the Esops, they issued directives to their nominees in June 2006 asking them not to exercise the options. The nominees ignored the directive and proceeded to exercise their options.

GIC and LIC have since removed their nominees and filed suits in courts against their nominees and also against L & T for not informing them about the issue of options in the first place.

These days independent directors on boards get Esops. When the institutions nominate directors, they advise them that they are entitled to sitting fees But any commission paid out of profit must go to the institutions. The standard directions to these effects were drawn up when Esops did not exist. So, the advisory makes no reference to how Esops should be handled. The nominees in the present instance have taken advantage of this ambiguity.

Board memberships especially at companies such as L &T can be onerous and it is fair to expect independent directors to be suitably compensated. If independent directors can get Esops, why not nominee directors?, you might ask. Well, this can be debated but the spirit of the instructions given by the institutions is clear enough: no pecuniary rewards to nominees other than sitting fees.

Suppose we grant that the nominees should not have exercised the Esops. How should they have handled these? Esops are meant for individuals, not institutions, so it is hard to see how the nominees could have transferred the Esops to the institutions.

Okay, maybe they should have transferred the shares? But that would have required them to exercise the options first. Who would pay for this? Should the nominees pay out of their pockets and get compensated by the institutions later?

Secondly,after getting the shares, how are the nominees to transfer these to the institutions? They cannot be transferred at the exercise price. They would have be transferred at the market price. In that case, the nominees would realise capital gains on which they would have to pay tax. Are they to transfer the capital gains to the institutions? Get the idea? The more you think about it, it becomes clear enough how messy Esops for nominees can be.

Why should nominee directors not get Esops? This is for the institutions to decide. But it's broadly accepted that compensation for independent directors must not be reasonable, not excessive, if they are to preserve their independence. Compensation in the range of Rs 35-45 mn does seem excessive. That takes us into another grey area in governance. You need to pay well to get independent directors on board. But if a company pays too well, it's hard to expect people to preserve their independence.

For now, it's over to the courts to resolve the L&T matter.