An Appreciation of Adam Smith’s The Theory Of Moral Sentiments

The capitalists of the world, the so-called free market  proponents ,bases most of their insatiable thirst for wealth  and justifies this thirst even when it  touches the borders of greed, on the theories of self-interest leading to society’s interests through what Smith referred to as the invisible hand in his famous work, Inquiry into the Nature and Cause of  The   Wealth Of Nations, popularly referred to as The Wealth of Nations. Smith’s  arguments were squarely based on certain assumptions and preconditions about the  normative sentiments and feelings  of human beings under different conditions. In fact he wrote about those preconditions  and assumptions  in a preceding book(in fact written in 1759 or 17 years before  Wealth),The Theory of Moral Sentiments, which details about the moral approbation and disapprobation of various aspects of human nature and behavior. According to Smith, man, who is by creation interested in self, forms moral judgments whereby self-interest gets separated because man is capable of putting himself in a position of a third, impartial person and hence can take an objective view of any issue.

Smith describes the human sentiments from a variety of normative and non-normative actions, behaviours, thoughts, nature, customs etc looking from a variety of  factors like propriety, merit, justice, beneficence, benevolence, self-approbation and dis-approbation, prudence, virtue etc. He also talks in detail about the corruption of our moral sentiments which leads to the disposition of men to admire the rich and the great, and to despise or neglect persons of poor and mean condition. While making observations on the corruption of our moral sentiments, he asserts that “we soon find that wisdom band virtue are by no means the sole objects of respect; nor vice and folly, of contempt. We frequently see the respectful attentions of the world more strongly directed towards the rich and the great, than towards  wise and virtuous. We see frequently the vices of follies of the powerful much less despised  than the poverty and weakness of the innocent”. This is precisely the reason why Naveen Jindal and the like get more attention and appreciation than Baba Amte and the like.

It seems that Smith had a definite intention of publishing the theory before Wealth. Wealth talks about individuals pursuing self-interests while the invisible hand may act upon top limit any excesses. But at the same time, he wanted the individuals pursuing self-interest (and those around him)to know how the moral sentiments of people work and influence.

Any proponent of free markets and hence capitalism must read Theory before he/she embarks on any venture that is in pursuit of satisficing self-interests.

Adam Smith the philosopher overrides Adam Smith the proponent of free markets with the Theory.

Why even the best minds get it wrong when it comes to Corporate Governance?

Recently Mr.T.T.Ram Mohan wrote a column in Economic Times( dtd Jan 31, 2013: Sebi Dodges the Central Issue) referring to the consultative paper on corporate governance by SEBI and considered the paper laudable except for that it fails to address the central issue, viz the appointment of independent directors. He goes on to explain how independent directors(IDs) shall be appointed and what should be the composition of them and discusses many other  many other like the  nature of the present day  IDs and other contentious issues like compensating IDs, diversity of IDs etc.

All his concerns & arguments are based on an assumption that IDs  are required there on the board because they have to take care of the interests of the shareholders other than promoters and management. But I’m afraid that he too misses the very concept why the very corporate governance is required. Corporate governance is essentially required because a corporate (be it public or private) is given the status  of an artificial entity. While this entity has been created for certain stated purposes, and company related laws and regulations everywhere in the world treats it as just another individual who can rent, buy and own property, has to pay taxes, will be punishable under the law etc, it doesn’t have the ‘life’ that we see in other individuals. The people working there give life to it. While employees working under the so called ‘management’ tries to achieve the physical  purposes for which the entity has been created, the board of directors oversees and ensures that the management does the right things to maintain the very rightful and valid ways  in which the entity is supposed to operate  and achieves its aims or the board must ‘govern’ it.

As we all know, the entrepreneurs who has great entrepreneurship in them have chosen the  corporate form to implement their ideas for specific reasons: the corporate can mobilize money from people beyond the promoters(the ability varying  depending on whether the entity is private limited or public limited); notwithstanding their ability to mobilize large funds from others, their liability is limited; and today in a globalized context, such entities can attract investments from any part of the world etc etc.

Despite all this knowledge that the entity is distinct  from them, the entrepreneurs or promoters can (and usually do): one, treat them as extension of the promoters themselves and treat the entity as an extension of his immediate family.”I established it, hence I will do whatever I want with the entity; it is my creation’, is a normal attitude. And, they treat it as too close to them, conveniently forgetting its lawful, separate entity status. While this may not much harm per se  to the entity, and because of the care and passion the entrepreneur/promoter shows may generate immense wealth too. But, it is likely that he may be tempted to take decisions which will  further the interests of himself or promoters or families etc, while ignoring the interests of the entity. Because he holds a sizable stake he will ensure that he is able to put through  decisions, all not necessarily auguring well for the entity. In India, the promoters hold high stakes , sometimes even absolute majority. Second, the entrepreneur very well knows that it is a separate entity and in the process of growth of the entity mobilizes more capital from outside and reduces his stake as time passes by  and some point of time  has only a nominal stake(which only a discernible investor or analyst will know) but still being in command pushes through all the decisions of the promoter or the family. The promoter gradually loots the entity for personal aggrandizement , leaving the entity in dangerous waters.

While Jindal Steel & Power  could be an example of the first category(where promoter Naveen Jindal pushed through a resolution for giving him power to determine the compensation paid to all whole-time directors including himself because he controls close to 59 % in the company), Satyam Computer can be an example for the second. Both ways are dangerous for the entity. And these are the typical examples where the governance of the entity comes into picture. If the board has only nominees of the promoters as its members, it is rather easy for the promoter to push any decisions through .That is when the significance of the IDs appear. Being independent of promoters and management, they can question the decisions promoters/management looking from the entity’s side. Does it help if IDS are nominated by other shareholders or minority shareholders? Not necessarily. IDs who are nominees of other shareholders will have definite briefs  to protect interests of those who nominated them; they can no longer take an independent view of what is good for the entity. Hence IDs must be free of any affiliation.

Now, regarding the percentage of IDs. When the developed world is moving towards a scenario  where there is only one or a very limited number of internal directors(like CEO and COO etc) and the rest are all IDs, we are trying to put the clock back. SEBI’s Clause 49 mandated 50% of the members shall be independent if the Chairman is full time or a nominee of the promoters, but the new company bill  is proposing the proportion of the IDs shall be one third. This ensures that the management always gets majority  approval for any decisions in the board room.

Where do you get good IDs ? India is supposed to have an excellent  management pool who can be tapped. Since the concept of IDs has been in practice only for  a decade or so, and they have always been nominated by management/promoters, initially it may not be possible to get excellent IDs immediately, but they can be developed over a period of time. The IDs shall be nominated by a nominations committee, constituted only of IDs. Management or other shareholders must have  no say in it.

Mr.Ram Mohan also discusses about the compensation of IDs. Both who should pay and how much should be paid is very important. An independent remuneration committee must take decisions on remunerations  to all directors  including the IDs. While deciding on how much, the committee has to look at the kind of involvement that the IDs have to take on, the ability of the company to pay, the size and profitability of the company, the prevailing remuneration in the industry  etc. There has been lots of concerns about the remuneration paid to IDs. Some apparently pay too high; of course nobody complains but get a little upset when they understand that the independent chairman at Infosys gets paid  more than the CEO and other IDs get paid  very close to the Whole-time Directors and also when they come to know that the  IDs  are paid a pittance  at Jindal Steel when the CEO  ‘takes’ Rs.73.42  Crores.