When the cost of reform is too high

In the wake of new personal liability rules in India, many independent board members quit and share prices tumbled.


In 30 seconds

  • Good corporate governance is important, but the introduction of personal liability rules for independent board members in India, wiped more than 1% off share values.
  • What can we learn from the Indian experience to better understand how to customise policy?
  • Could a more established liability insurance market have mitigated the fall in firm value?

Emerging economies are diverse, but how often do policymakers reflect institutional diversity in regulation?

To what extent should they transplant rules from developed economies, or create something more bespoke?

The reality is that growth isn’t a smooth road. It is a complex policy journey with friction and speedbumps pushing well-intended regulations, in unintended directions.

This is one of the takeaways from the work of Lakshmi Naaraayanan, Assistant Professor of Finance at London Business School, whose research focuses on reforms in emerging economies.

In a new paper, published in the Journal of Financial Economics  ‘Does personal liability deter individuals from serving as independent directors?’ Naaraayanan develops this focus in the context of corporate governance.

Collaborating with co-author Kasper Nielsen, a Professor of Finance at Copenhagen Business School, they examined the exodus of independent members from Indian boards and its connection to a fall in share prices, in the wake of personal liability rules. The paper shows that shareholders reacted negatively to the enactment of the law, and stock price reactions to director replacements resulted in firm value falling by 1.16%.


Poor governance

This drop in value matters because developing economies are characterised by low corporate governance standards, and many countries are considering following in India’s footsteps.

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Steve Forrest/Workers' Photos

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“It is a specific friction which also applies to broad range emerging economies.”

“My work is interested in which frictions and barriers are getting in the way of economic growth and what policymakers are thinking, when they try to navigate their route through to becoming a developed country,” says Naaraayanan. “We often find that when you look closely, the paths to growth can look very different.

“When we started this project, we had two main hypotheses. One is that strict liability would make boards more effective. It would give firms recourse, if things go wrong, which in turn, means you should get more responsible decision making.

“The other hypothesis is that if you are a risk averse person, and you are told that ‘if I find anything wrong in the company, I’m going hold you responsible,’ it could deter people from sitting on a board at all.”

After the reforms came into effect, the paper looked at which directors would choose to leave, who would replace them and what those moves would do to firm value. Using a short window market analysis around each event, which excluded other factors in the price move, it became clear the market did not like personal liability rules.

What the data revealed is that both hypotheses where in play. Both experienced and inexperienced board directors cut the number of boards they sat on to avoid reputational risk, hitting firm value.


Diverse paths to growth

“We need to understand what is happening as markets develop,” explains Naaraayanan. “Everyone benchmarks what happens against developed economies, but they didn’t just emerge spontaneously. Is every country going to take the same path to growth? What can get in the way of growth? These are questions which interest me.

“How better governance rules and norms are developed are usually taken from the book written by developed economies. To follow a path set elsewhere, you are saying we should just replicate those rules in a different country and expect the same result, which is missing a more complete picture.

“The paths to growth can look very different.”

“This paper is looking at one role of policymakers, in making sure boards are functioning well by having personal liability for directors. Many countries are now considering the same policy as they progress toward developed economy status. It is a specific friction which also applies to broad range emerging economies.”


What is the net effect?

The effect of the new rules In India was not entirely negative. While on one hand high-quality directors sat on fewer boards, of the boards they stayed on, they attended more meetings and spent more time helping managers to create firm value. On the other hand, one interpretation of the wave of resignations was as a negative comment of the health of the firms, which also suffered the loss of oversight previously provided by those board members who had quit.

“What went wrong is that India went from a broad regime with no liability to one of strict liability when it had no liability insurance market,” explains Naaraayanan. “In more advanced jurisdictions there is a lot of interest in reducing liability through insurance."

“There needs to be a balance between liability and insurance, so you have pool of high-quality directors willing to take an appropriate amount of risk.”

Insurance protects board members from negative shocks outside of their control but not from their own shortcomings, negligence or corruption.

Further work

A sister paper by the same authors, investigates the impact of regulations that enforced gender quotas on boards and finds evidence for how gender quotas have deepened the talent pool by having more female directors on corporate boards, even in patriarchal societies.

It is hoped the papers will stimulate further study in the field and give developing nations a deeper insight into their economic paths ahead.