M. Damodaran, former chairman of the Securities and Exchange Board of India, sees at least two major positive trends for Indian business. One is a push for better corporate governance, such as the inclusion of more independent directors on boards and stronger auditing standards. Another is the fact that, unlike previous generations, India’s younger entrepreneurs “don’t shy away from asking the tough questions” and are willing to ride out failure in order to succeed. In an interview with Wharton management professors Jitendra Singh and Harbir Singh, coauthors of the book The India Way: How India’s Top Business Leaders Are Revolutionizing Management (with Wharton’s Peter Cappelli and Mike Useem), Damodaran spoke about what he envisions for India’s business future.

The interview is in two parts. In the second, M. Damodaran asks Harbir Singh and Jitendra Singh some questions about their research on Indian companies.

An edited transcript of the conversation follows.

Harbir Singh: One of the issues we discovered in our research for [our book] The India Way, was that when we asked respondents whether Indian corporate governance will go the same way as U.S. corporate governance in the future, about 51% said, “Yes.” But the rest were quite mixed, and a significant percentage said India would find its own corporate governance regime. Some felt other models would play a role. Where do you see Indian corporate governance going in relation to what we see in other economies?

M. Damodaran: On the subject of corporate governance in India, two or three things have bothered me. Given that the shareholding pattern is different from what exists in the United States — in that we still have a large number of companies with significant promoter shareholdings — replicating the U.S. model might not [be the solution] indefinitely. The reason why Clause 49 of the listing agreement [to the Indian stock exchange, which came into effect in December 2005] takes significantly from the provisions of [the United States’] Sarbanes-Oxley is that first, it was the one big model that was available, and second, you needed to be seen doing something quickly because if you did not have a prescriptive arrangement and went looking for the ideal one that met your shareholding pattern better and so on, you would have taken too long.

At some point, we might even have to think in terms of two-tier boards for some companies — with a supervisory board and a management board. Especially in large public-sector undertakings where every functional head is a board member, the size of the boards are unwieldy, which does not lend itself to very effective collective performance. Also, to get good people and ensure that you give them the right kind of protection from Indian courts and legal processes, those with part-time board members might need to look at two-tier boards. That might be the way forward.

Harbir Singh: What is clear is that the agency problems we see in the U.S. are really between owners, or shareholders, and managers. But in the Indian setting, you also have agency problems between majority and minority shareholders, in the sense that majority shareholders may want to pursue certain goals and minority shareholders may be frozen out. In the enforcement of Clause 49, what are some of the ways one thinks about agency problems?

M. Damodaran: [When you have] significant shareholders and minority shareholders — even if you look at them as part owners of the company — their interests and concerns clearly should be shared. But there could be a personal agenda driving some of the larger shareholders. You need to put in structural arrangements and have legal provisions that protect not just minority shareholders, but also other stakeholders.

One question that needs to be addressed here — not just in India but elsewhere: Who is responsible for ensuring corporate governance? The answer to this varies even across jurisdictions. In some places, it is a securities market regulator, [in others] the Ministry of Corporate Affairs or whoever. Going forward, we should see provisions in the Companies Act that stipulate what needs to be done by way of structural arrangements rather than leaving it to the listing agreement, which would not have the same legislative strength as the Companies Act.

Better disclosures on a continuing basis have to be ensured so that minority interests are better protected. [It also requires more rigor in terms of] board composition by getting good nomination committees and getting auditors to recognize that the real clients are not the people who signed the engagement letter but the people who are the shareholders and other stakeholders. That is a huge issue in terms of perception. Some of these will have to be addressed.

Jitendra Singh: The important gap in the context of Indian corporate governance seems to be between how things look on paper — for want of a better phrase — and what actually happens in the boardroom. This problem is not unique to India. But given the state of corporate governance and how it has become more important in the last few years, perhaps it is more acute or attracts more attention in India. To what extent is this something that needs to be understood in the context of Indian culture broadly, of Indian family-owned companies more narrowly, and even more narrowly of the psychological and cultural dynamics, including the chairman’s leadership of the board since he or she is after all a role model and has to set the right tone. What about this gap?

M. Damodaran: We must recognize, not just in India but elsewhere, that prescriptive arrangements are necessary but they are never sufficient. We need to have a framework that ensures minimum standards. We always believed at SEBI while I was there, and I’m sure it continues, that Clause 49 is at best a starting point. It only holds a mirror up to a company to see where it is at a point of time in relation to the minimum practices it needs to have. If you look at it as a box-ticking exercise, as some companies do, you are not going to make progress toward good governance. You will stay within compliance and not move toward effective governance.

A huge cultural issue is also linked to the ownership structure [around] the person who set up and is identified with the company. In some companies, [those people] even lend their name to the company so that you don’t see the company as being different from the person who set it up. In that case, people on the board tend to look to the person identified with the company to provide a kind of thought leadership continuously. In some sense, that tends to have an impact on the independence of boards no matter how eminent the people in the boardroom are.

One issue that hasn’t been discussed often enough in or outside of India is the separation of the chairman and chief executive position. I believe combining these two roles is the ultimate negation of corporate governance. You have the chairman, who is supposed to lead the board by asking management questions about how the company is governed, and you have the chief executive who represents management in responding to the concerns and issues. If both roles reside with the same person, the board can’t really start providing the collective leadership that the company needs.

The other issue in India is a cultural one. People don’t leave personal friendships outside the boardroom and get into boardrooms as equals and think independently. Personal relationships outside boardrooms tend to have an impact on boardrooms. There is only so much you can prescribe. For example, using material relationships as a test to decide who is independent — my best friend can be independent because our friendship is not a material relationship according to the listing agreement. Yet he or she might be the person who is most affected by being on my board and not thinking independently…. Friendships are not, in law, defined as material relationships.

The prescription on paper is fine but it is at best a starting point. In Indian boardrooms, there is a long way to go. Based on my own observation of Indian boardrooms, the role of the chairman as not just the leader but as a kind of ultimate arbiter affects free and frank discussions. Even if the chairman has not expressed an opinion, people tend to second-guess him or her, and then it almost seems as if they are tailoring their opinions to suit the requirements of that person. That is not doing companies any good.

Jitendra Singh: The implication is that if independent board members engage in self-censorship, it is not necessarily in the interest of the company.

M. Damodaran: It is. You have problems in two respects. You have one set of problems in which independent directors don’t function independently. You have another set of problems in which people don’t understand their role when they come into boardrooms and see themselves as the opposition party to management — that is, I need to oppose everything management comes up with because I am the representative of a minority group that only sees what the majority is doing wrong….

Jitendra Singh: The question is how to get the balance.

M. Damodaran: One thing that needs to be done is for a nomination committee comprising independent directors to create a universe from within which their successors are chosen…. That is also critical.

Harbir Singh: That leads to the attributes of effective, independent directors. With the implementation of Clause 49, there is a large demand for independent directors. That speaks to the issue of availability and quality.

M. Damodaran: When Clause 49 was made part of the listing agreement, one of the reservations — even before it was introduced — was where were we going to find the independent directors. Do we have that many? As a private initiative supported by SEBI, I had the privilege of inaugurating a website that collected a lot of names, and we discovered that in a country as large as India, there are people who have both the ability and willingness to serve on boards. The problem is whether management [teams] are willing to look around. Do you look within your school network, college network, immediate neighborhood and club membership? Or are you willing to cast the net a little wider?

The other issue, which again is getting lost, is the legal responsibility attached to non-executive directors. How are we protecting them? Is directors and officers liability insurance adequate? In India, it’s not a concept that has taken off. Is the law prescribing a knowledge test to help you decide what a non-executive director ought to be held responsible for? These are thoughts that hopefully will generate interest in the future to bring people into boardrooms — those who will take the risk.

Today, it is risky sitting in boardrooms. You have legal liabilities but you don’t have the knowledge that management has. There is clearly a disconnect there. The numbers are available if you go looking for them, [but] what is missing is induction material. There are many big companies that don’t even send letters to directors saying what is expected of them. There is no induction material or training. There is no clarity about the role. Clearly, [board members] are performing sub-optimally in that situation.

Harbir Singh: The induction is really about the rules of the company. That leads to [the question of] what is the skill set that makes them most effective in the boardroom? And what about the issue of boardroom dynamics?

M. Damodaran: Boardroom dynamics are an interesting issue. I have recommended to a couple of boards that I do not sit on but advise that they change the seating order around the boardroom table so the same people don’t sit in the same chairs every meeting. Even that changes the nature of interaction in boardrooms. People who had remained silent are now opening up. Simple things, really.

Do independent directors — I prefer to call them non-executive members since you can’t label them independent unless he or she demonstrates independence — understand their role? Do they know what they have to do? Are they equipped to do that? Are they compensated appropriately? Do they get to spend enough time [on issues in accordance with] how many committees they serve on? These are issues that need to be addressed. And as for your question about the practice [versus the paper], regrettably many of them do not get addressed.

Jitendra Singh: Let me raise a more provocative issue simply because it helps highlight an important issue: The chairman of a large group of companies — they are majority family- owned and some are public companies — said to me, “I really don’t understand all this talk about at least 50% of directors needing to be independent, non-materially related….  Let’s say I own 75% of the equity — my family owns it. Are you really serious that I am going to do things that are not in the interest of the shareholders, that is, me and my family? And what is this need for independent directors?” What do you think of this person’s comment? How can one still make the case for strong, capable independent directors in spite of his point?

M. Damodaran: At one of our early conferences on corporate governance after Clause 49 was introduced, a person sitting in the front row … said, “My company has declared profits for the last 20 years. I have had no investor complaints of any kind. We are a publicly listed company. Why do I need to get independent directors? It is running very well.” The answer I gave him and the answer I give to other people is: As long as you do not own 100% of your company — you or your family — and you have raised money from the public under the [agreement that] you are to apply it to a certain productive endeavor — the person who parted with the money needs to have a system to know that it is being applied to that endeavor, and it is not being invested in the stock market or doing something unconnected with the company.

The fact is that somebody owns 75% and would ordinarily be expected to act in the interest of the company. There are any number of instances of people who have said, “I can benefit personally if 100% of my interest is a private agenda, which is going to reward me at the expense of the company.” We saw this with the textiles strike [in Mumbai in 1982] took place. A lot of textile mills became sick. The promoters did not become sick. How did that happen? They were all majority-shareholder companies. Ultimately, people need to recognize that no matter what the majority ownership is, getting good people on the board is good for the company.

Harbir Singh: Let me pick up on one point that someone observed many years ago, which is one of the key drivers of the U.S. corporate structure: It was that the separation of ownership and control provides good checks and balances. What you just pointed out was that even if I am a 75% owner, the fact that I also control [the running of the company] can result in a lack of accountability. I may extract my money because I also control the financial statements. But India has high levels of majority ownership. What would be a good governance mechanism?

M. Damodaran: You need to insist on having non-executive directors on the board. The number is not critical — it is not 50% or one-third that is critical. [All you need is] one strong independent director who says, “I am not going to associate myself with decisions that I think are not right.” Ultimately, this doesn’t remain within the boardroom. It tends to get out and have an impact on the reputation of the company. People will not take that person lightly, even though he or she might get outvoted.

Notwithstanding the pattern of ownership, you need to ensure you have non-executive directors in place. More importantly, you need to prescribe continuous disclosure. You need to ensure that auditing standards are high and auditors who don’t measure up are quickly identified. Unfortunately, in many of the professional bodies, the disciplinary power also resides in a subset of the bodies. Therefore, it doesn’t get its act together quickly or it is fairly weak in its response to fellow professionals stepping out of line. You need stronger auditing standards. You need a judicial system that addresses issues quickly, which regrettably is not the case in India.

Jitendra Singh: If my compensation from a particular independent directorship becomes too significant of a proportion of my overall compensation, it tends to compromise my independence regardless of how vocal I might be. This becomes a particular issue when you have directors for whom compensation is a larger percentage of their annual income than for others. Their incentives start to change. Could you comment on that and offer any answers to how much percentage for any board is too much?

M. Damodaran: Compensation is a critical element that clearly impacts independence one way or another. You can get people who are non-performers if you compensate very little. If you over-compensate, and honestly one doesn’t have a number, that could have an impact on independence because the critical issue is not whether you get a person who is independent on day one, but whether that person stays independent as he or she gets compensated in a manner that is out of sync [with the need to act independently].

Clearly the numbers will vary. One way is to look at it is as a percentage of compensation. But I have heard the opposite argued: That people who don’t earn a lot of money [in terms of percentage] are well intentioned — let’s say a very rich lawyer … [as opposed to] a pensioner civil servant. But to conclude that therefore [a person’s] independence might be impacted adversely [if the compensation] is a larger percentage might not really be the issue. It is the manner in which compensation takes place that could be more critical.

When do you compensate a director? Do you compensate a director by deferred payment after he or she has ceased to be on the board? While I am on a board, if my compensation — whether it be in stock options or otherwise — relates to my immediate performance, I [might be] compelled to deliver on numbers that might be not reflect [what’s actually happening in the company]. Can we think of a way that after I move out of a boardroom, I get compensated for what I might have done?

Harbir Singh: A raging debate in the U.S. today is that corporations should be accountable mainly — and almost only — to their shareholders, and not engage in any activities that don’t directly result in measurable shareholder value. In contrast, when we interviewed Indian leaders for our book, we were taken aback that many of them spoke of a broader mission, which Milton Friedman, the originator of this thinking, is [the equivalent of] imposing a tax on shareholders. Is this just evidence of a different societal structure? Is it because in India, a large social agenda needs to be performed? Is it that these leaders are more socially responsible?

M. Damodaran: To say that, as a group, they are socially more responsible would be, to put it bluntly, giving them more credit than they deserve. That said, many of them see great value — including great commercial value — [in what they do] and I’m not for a moment [dismissing] them for having a higher purpose in rewarding stakeholders other than shareholders. There is great commercial value in rewarding stakeholders in the society in which you live other than shareholders. [You can forge a] sustainable existence and a peaceful, productive relationship with people who are not your shareholders — maybe not even a part of your workforce — but are in your immediate neighborhood. [Building a] sustainable relationship could be an investment in the future of the company. Many forward-looking, progressive Indian businessmen, industrialists and entrepreneurs have recognized value in this, which is why the debate in India no longer should be confined to shareholders.

Also, there is evidence that shareholders and other stakeholders might not have conflicting interests, even though [it might not seem the case when] money that might have gone to shareholders in the short term — by way of returns on capital appreciation — is being spent on other things.

Part Two

M. Damodaran: Based on your studies and interactions with Indian leaders and your observation of people in other markets, do you see a difference between first-generation entrepreneurs who have built businesses [and the generations that succeed them]? Is the founders’ value system significantly different from the inheritors of the businesses?

Jitendra Singh: Let me give you some anecdotal examples. There are firms like Tata … that have been known for decades, if not longer, for their very charitable acts. Legacies as companies that do good work have been handed down to other generations. One might have a hypothesis that some of the younger entrepreneurs do not have that same level of thinking about the social or broader national agenda [as their predecessors]. I would say this used to be true through the 1970s and 1980s and perhaps even the early 1990s. I would also tell you, based on my experience dealing with leaders in India, one very positive and pleasant surprises has been in the last five years or so … how sincerely many of them feel engaged with the national agenda. Some kind of cultural shift is taking place. It probably was more true some years ago that the brash, young entrepreneurs weren’t as charitable as the older, well-established family-run companies. I’m not sure it is true any more. Certainly there are many counter examples.

Harbir Singh: One of my thoughts is about post-1991 when the markets opened up [in India] and when we talked to some CEOs about their thoughts on deregulation of the Indian market and their future in the global economy. What was fascinating is that because they did not think they would do well competing with all the multinationals. But as they begin to respond to the multinationals, there has been a self-confidence among many of them in our interviews today. It not so much a national pride — although that is clearly there — as doing something for India but that it is our time on the global stage. A little bit of that theme is emerging. Specifically on the multi-generational issue, we don’t have enough observations on different generations so this is largely speculative. But you raise an important issue, which is the founders had a sense of mission, purpose and resilience that is not always transmitted to the next generation.

We identified four attributes. One was broad mission. Another was resilience and adaptability. A third was creating a value proposition and a fourth was employee engagement. The one that is hardest to transmit across generations is resilience. If you have not had those moments of sheer frustration and exasperation … it’s the hard one to pick up.

Jitendra Singh: Harbir triggered another thought — the India in which Harbir and I grew up, perhaps not that distant from the India in which you grew up in the 1960s and 1970s, was one where the typical middle-class Indian might have had all kinds of dreams and fantasies — particularly financial dreams — but were almost certainly going to be impossible to achieve. What has been very dramatic in the post-1991 reform period is that fairly significant numbers of people have been wildly successful beyond their wildest dreams. For many of them, their appetites are completely satiated; for others, it will never be enough. I think that is behind the psychology of saying, “What can I now do for the rest of society?” This is a change. I was not seeing this ten years ago, but started seeing in the last five years.

M. Damodaran: Is it also related to the greater acceptance of business as a way of life? [There was a] distrust of business, say, three or four decades ago, [when it was felt that there were] people who made money for themselves versus people who identified with the national agenda and progress and they were doing their bit for the larger cause…. [Today] there is a higher acceptance of what you mentioned and a higher confidence level born out of successful acquisitions overseas. We had always seen Indian companies as targets of acquisitions never as acquirers overseas. We are seeing big stories in not one sector or two but across [a number of] sectors. Even small companies are looking at other companies. The confidence level plus a higher acceptability and the manifestation of people who have worked in industry accepting responsibilities in government positions….is all this creating the view that people can earn their keep from business, but that they should also work for stakeholders [and not just shareholders]?

Harbir Singh: India is probably going through the phase that the U.S. went through in the early 20th century when the Rockefellers and the Carnegies transformed society. India has its own versions [of the Rockefellers] today and the velocity of change that you have certainly been part of really collapsed 40 or 50 years of change into 15 years. People have become larger than life, and others have seen that and felt there is a larger stage on which they need to operate and it’s not just about the bottom line…. But I just want to reinforce what you said — that business now has more positive images than it did in the past and that is related to the fact that business has helped transform society.

Jitendra Singh: India is undergoing what may in the future be remembered as a watershed period. What we are talking about are the details of cultural change — values are changing. It is systemic but an important piece of it is the culture. I always knew when the reforms were taking place in 1991 that it would take a couple of decades for the collateral systemic changes to take place. They are happening and they are very positive for the country.

M. Damodaran: What one is noticing is that young India is asking questions that had not been asked earlier. The courage of conviction is more evident today in business than it was earlier. It is no longer a question of preemption of capacities in a licensing regime. It is not a question of whom you know, but how good your project or idea is. People are beginning to recognize that this is the time and place for those who want to take advantage of the opportunity where India finds itself. I was having a brief conversation this morning with one of your students and he asked me, “What should a young person do?” I said, “Go where your heart takes you.” Because today the range of options available to a young person is greater [than it has been].

Somewhere India has also unleashed its entrepreneurial abilities. We never suspected some years ago that there was so much entrepreneurship in India. People are willing also to ride out failure and take a second shot. People are willing to take chances. Decision-making is improving. Now people are not shying away. That is hugely positive.

Jitendra Singh: The last thought I would share before we move on is that my understanding of cultural processes and how they evolve is that it is very hard to predict the details of what will happen. It will happen. And that’s what fills me with absolute optimism for India’s future, for the rest of our lives for sure and perhaps longer.

M. Damodaran: I think of it in the same way. So long as it is going in the right direction, one shouldn’t worry too much about the pace of change.

Harbir Singh: With the success of home-grown Indian firms — in professional services, in particular, but also manufacturing-based companies and so on that growing via foreign acquisitions and global operations — there is a sense of confidence that younger people can pursue a variety of careers and that they are equal to people from anywhere in the world, and perhaps stronger than them because of the intensity of competition. What do you see in terms of the opportunities they have and the positive attributes of their current environment? And what are some challenges that they should make sure they deal with?

M. Damodaran: The one positive attribute of youth — and one that we are seeing evidence of — is that they are irreverent. They are on occasion respectful, but they don’t shy away from asking the tough questions. That is something positive about this generation. The major task at hand is that looking at the [young] Indian population. We talk in terms of the “demographic dividend”. We say this is India’s huge plus. But I see this as a major negative unless we [teach] this young India skills that both the Indian workforce and the whole world needs. India could provide the workforce to the world if it [had] the skills. Investing in skill sets that are relevant and getting the energy of young India  married to the requirements of tomorrow are critical.

Jitendra Singh: It seems to me that sometimes corporate governance goes awry when, say, the chairman or even executive directors are much more committed to a particular outcome — like who should be the next independent director or CEO — as opposed to a process that is likely to produce the highest quality outcome. In some ways, this misplaced commitment sometimes leads to a lower quality outcome than an appropriate commitment to process and letting the process run its course. What do you think?

M. Damodaran: I agree with you. Corporations need to recognize that none of this can be driven by individual processes. There must be systems. There must be procedures. There must be access to outside expert advice. One thought that hasn’t gained ground in India yet is getting outside experts to evaluate the performance of boards and their directors. This would lead to a situation in which everyone who sits in a boardroom sees that he or she has only one indivisible constituency and that is the company. [They should be] creating an environment in which people can perform to their potential and … seeing that they understand their role and that they get the appropriate induction and training and a protective environment….

Where does management’s role come in and where does the board’s role come in when we talk about everything in terms of: Getting the right people [on a board] by [using] a process; ensuring that they are compensated in a manner that rewards them without impacting their independence; ensuring that together they deliver to one indivisible client, which is the company. That is more easily said than done but that is what needs to be addressed.