Company Law - Independent Director

Introduction

Corporate Managements the world over are under a scanner, particularly after the Enron debacle of 2001 and other scandals involving large US companies such as WorldCom, Qwest, Global Crossing, and the auditing lacunae that eventually led to the collapse of Andersen. In India barring a few exceptions, the performance of the corporate sector has left much to desire.

Unscrupulous promoters have taken ordinary investors for a ride over the last several years. The Government has been forced to think of some remedial measures to stem the tide of corporate larceny. One of the ways has been to continuously raise the standard of Corporate Governance.

While it is recognized that corporate governance can not be really enforced by law, at the same time, continuous efforts are being made to effect changes in the applicable law, so as to improve the standards of Corporate Governance.

At the core of corporate governance is the board of directors. A joint-stock company is owned by the shareholders, who appoint a board of directors to supervise management and ensure that it does all that is necessary by legal and ethical means to expand the business and maximize long-term corporate value .

The measure of the board is not simply whether it fulfils its legal requirements but more importantly, the board’s attitude and the manner it translates its awareness and understanding of its responsibilities. An effective corporate governance system is one, which allows the board to perform these dual functions efficiently. The board of directors of a company thus directs and controls the management of a company and is accountable to the shareholders and in this context the non-executive directors bring external and wider perspective and independence to the decision making

Although there is a legal duty on all directors to act in the best interests of the company, it has long been recognized that in itself this is insufficient to give full assurance that these potential conflicts will not impair objective board decision-making. These individuals bring a dispassionate objectivity that directors with a closer relationship to the company cannot provide

Directors are fiduciaries of shareholders, not of the management. Even though this does not imply that the board must have an adversarial relationship with the management, but there exist a natural potential for conflict between the interests of executive management and shareholders in the case of director’s remuneration, or audit (where decisions on the financial results can have a direct impact on remuneration), or indeed in a range of other instances.

And in all these instances where the objectives of management differ from those of the wide body of shareholders, the non-executive directors on the board must be able to speak in the interest of the ultimate owners, discharge their fiduciary oversight functions. This is why ‘independence’ has become such a critical issue in determining the composition of any board.

Background

The 1992 Cadbury Report initiated a debate about the main functions and responsibilities of non-executive directors. Today, it is widely accepted that non-executive directors have an important contribution to make to the proper running of companies and, therefore, more widely to the economy at large.

In the Indian Context, SEBI constituted a Committee on May 7, 1999 under the chairmanship of Shri Kumarmangalam Birla, to promote and raise the standards of corporate governance, based on the recommendations of which, a new clause 49 was incorporated in the Stock Exchange Listing Agreements (“Listing Agreements”).

As a result, all the listed companies were required to have Board of Directors, comprising independent directors and an audit committee comprising mainly of independent directors.

One of the main recommendations of the Kumar Mangalam Birla Committee was that in a board with an executive chairman, at least half the members should be independent. In case of a non-executive chairman, one-third of the board members should be independent. This was suggested to keep promoter-directors from hijacking the functioning of the board .

Going a step further, the Naresh Chandra panel set up on 21 August 2002 to further strengthen the Corporate Governance system in the country, made no distinction between a board with an executive chairman and a non-executive chairman—all listed and unlisted companies with a paid-up capital and free reserves of over Rs 10 crore or a turnover of at least Rs 50 crore should have half the board members as independent directors .

Moreover it has been recommended that all companies with a paid-up capital of Rs 10 crore or more or a turnover of over Rs 50 crore should have a board of at least seven with four independent directors .

Meaning of Independent Directors

At the core, it means something very simple, that a person should be able to exercise his or her reasoned judgment without being constrained or unduly influenced by pressures either from management or any dominant shareholder or stakeholder .

The term “independent” directors had not been precisely defined anywhere and it is with this backdrop that Kumar Mangalam Birla Committee attempted to define Independent directors as directors “who apart from receiving director’s remuneration do not have any other material pecuniary relationship or transactions with the company, its promoters, its management or its subsidiaries, which in the judgment of the board may affect their independence of judgment” .

The Birla Committee expressed its concern that the definition should be “sufficiently broad and flexible” so that it does not “become a constraint in the choice of independent directors on the boards of companies”.

In other words, the Birla Committee report put the onus on the management to decide as to whether a particular director was an independent director or not for meeting their requirements of Clause 49.

But in view of the fact that it has been the practice of most of the companies in India to fill the board with representatives of the promoters of the company, and independent directors if chosen are also handpicked thereby ceasing to be independent, the Naresh Chandra Committee taking in to account various international definitions of independence has provided for a fairly comprehensive definition of “Independent Directors”, which is in the nature of providing negative covenants or disqualifications . The recent Narayana Murthy Committee has also defined the term “Independent Directors” in the lines of the Naresh Chandra Committee.

It seems pertinent at this point to differentiate between Non-executive directors and Independent Directors. The former constitutes all those directors that do not belong to the management of the company, whereas the latter would mean only those directors who are not only non-executive in nature but also do not share any type of material or pecuniary relationship with the company, or do not suffer from the aforementioned disqualifications. For example, a supplier of the company will certainly be categorized as a non-executive director, but he shall not be considered as an independent director.

It is also argued by some that whether these directors can really be called independent in the real sense if they are appointed by the shareholders themselves.

Change in law

The Government has proposed to incorporate a new provision in the nature of Section 252 A in the Companies Act, 1956 to define the term independent director . It mentions 11 negative attributes or disqualifications which would render a person being incapable of being appointed as an independent director. These are extensions to the recommendations of the two committees.

Ambiguities in the Definition

Under the definition neither a former supplier/vendor of goods or services nor even a customer can be considered for appointment as an independent director. The inclusion of a `customer' in the prohibited list is ambiguous and unfair since the expression “customer” has not been defined. Will the term be construed as only regular purchasers, those with long standing relationship or would it include even a casual one-time purchaser of any products of the company?

Moreover as stipulated in the definition, no one who holds 2 per cent or more of the securities of the company, having voting rights, can apply for the post of independent director. But can he get circumvent the provision by transferring his holding to his spouse or any of his children who have attained majority if the objection is only to his continuing to retain 2 per cent of the company's equity capital in his own name?

The definition also provides a disqualification for those who hold any equity shares of the company during his term of office as an independent director "and six months after he ceases to be an independent director" . This seems to be a extraneous provision since the ban on the entry of any one holding "two per cent or more in the securities of the company having voting rights" implies that there can be no objection to his holding less than 2 per cent shares at the time of his induction into the company or even afterwards.

In any event, it is beyond comprehension as to what purpose does a restriction on his acquiring shares after his retirement from the company serve? Is it the intention that such acquisition of shares within six months after he has ceased to be a director will be held against him if he seeks the post of an independent director thereafter?

Role of Independent Directors

An independent non-executive director is expected to effectively participate in formulating strategy of the company. They must use their professional knowledge, experience, specialty and vision to the advantage of the company. For instance, if one serves as an independent non-executive director of a company and if he is a lawyer too, then he must apply his professional knowledge and experience in the legal aspect and corporate governance of the company. Therefore being a lawyer independent non-executive director, he has a bigger legal responsibility than non-lawyer independent non-executive directors.

It is also expected of them to oversee the management and the company in implementing the rules, procedures and plans established, that is, to see whether the company operates along the established orbit and to check as to whether the company has established a proper and effective internal monitoring system and procedure

It is also very important for independent directors to air their affirmative and objective views and take independent decisions. As an independent director, it is expected that they are absolutely impartial in their decision making by taking into account all available information, instead of casting votes according to the views of shareholders who have appointed him.

As an independent non-executive director, an important task is protecting the interests of all shareholders & stakeholders, which would include creditors, employees of the company. For instance at the time of entering in to contracts, they are expected to be independent of the entire negotiation process and according to the appraisal of independent financial advisors, provide professional views to all the shareholders with no conflict of interests so that they would get clear as to or not to adopt such contracts.

Apart from the above four aspects, it is required that the two most important committees, i.e. Audit Committee and Remuneration Committee, constituted in order to achieve a strong and an effective system of corporate governance, also are required to mainly formed by independent non-executive directors.

Even though Clause 49 of the Listing Agreement prescribes that the Audit Committee of listed companies must consist exclusively of non-executive directors, of whom the majority must be independent, it has been recommended by the Naresh Chandra Committee that Audit Committees of all listed companies, as well as unlisted public limited companies with a paid- up share capital and free reserves of Rs.10 crore and above, or turnover of Rs.50 crore and above, should consist exclusively of independent directors .

In light of the growing importance and need for more active role of independent, it is being recommended that these directors should be those who possess knowledge, skill and experience in areas as diverse as Finance, Business strategies, Product or Service development, human resource development .

The Naresh Chandra Committee has identified four other areas that are also rapidly gaining prominence in modern business. These are (i) integrated logistics and end-to-end supply chains, (ii) R&D, (iii) the creation, maintenance and scalability of web-based IT systems that deal with internal processes as well as relationships with customers and vendors, and (iv) sophisticated, transparent investor relations. However the initial expertise can be sought from various consulting firms and specialized service providers .

It is important to recognize the fact that excellence attracts excellence. Therefore it is important for the companies to make a sustained effort to attract requisite talent at the board level — people who can contribute their expertise to make a difference not only to governance, but also to long-term corporate performance.

International Perspective

The need of Independent Directors has been addressed in great detail in several international reports on Corporate Governance, notable among them are the Report of the Cadbury Committee , the Combined code principles of good governance and code of best practice , Hampel Committee on Corporate Governance , Higgs Committee Report that deals with review of the role and effectiveness of non-executive directors , International Corporate Governance Network (ICGN) principles of Corporate Governance , Corporate Governance Rule proposals of the New York Stock Exchange , Bouton Report on Corporate Governance in France.

'Independent' directors were defined in the Cadbury Report as persons who “apart from directors” fees and shareholdings are independent of the management and free from any business or other relationships which could materially interfere with the exercise of the independent judgment.”

The Cadbury, Hampel and Higgs reports, some of whose recommendations are included in the revised Combined Code of the London Stock Exchange, stresses that the board should include independent non-executive directors of sufficient calibre and number, for their views to carry significant weight in the board's deliberations.

Among the aforementioned reports the Higgs report has provided a fairly exhaustive definition of “Independent” Directors, which is as follows:

Independence

A non-executive director is considered independent when the board determines that the director is independent in character and judgment and there are no relationships or circumstances which could affect, or appear to affect, the director’s judgment.

Such relationships or circumstances would include where the director:

 is a former employee of the company or group until five years after employment (or any other material connection) has ended;

 has, or has had within the last three years, a material business relationship with the company either directly, or as a partner, shareholder, director or senior employee of a body that has such a relationship with the company;

 has received or receives additional remuneration from the company apart from a director’s fee, participates in the company’s share option or a performance-related pay scheme, or is a member of the company’s pension scheme;

 has close family ties with any of the company’s advisers, directors or senior employees;

 holds cross-directorships or has significant links with other directors through involvement in other companies or bodies;

 represents a significant shareholder; or

 has served on the board for more than ten years. The board should identify in its annual report the non-executive directors it determines to be independent. The board should state its reasons if a director is considered to be independent notwithstanding the existence of relationships or circumstances which may appear relevant to its determination.

The London Stock Exchange's Combined Code, that effectively codifies the main features of the Cadbury, Hampel and Higgs reports for listed companies, advises that the balance of executive and non-executive directors should be such that no individual or small group of individuals can dominate the board's decision-taking and that Non-executive directors should comprise not less than half the board.

Analysis

Whereas the above definition makes it clear that it is important that a non-executive director is not so dependent on their shareholding as to prejudice independence of judgment, there exist a contrary view that any degree of share ownership as a per se bar to “independence” (absent such other factors as an employment relationship or other financial or personal tie to the company). They argued that directors who own or represent institutions that own very significant economic stakes in the listed companies are often effective guardians of shareholders’ interests not only as members of the full board but also of compensation and nominating committees, while directors whose only stake in the membership on the board is the director’s fee may be unduly loyal to management.

This issue has been clarified by the New York Stock Exchange in subsection 2 of Section 303A of the New York Stock Exchange’s Listed Company Manual that since the concern is independence from management, ownership of even a significant amount of stock, by itself, is not necessarily a bar to an independence finding.

A similar issue was raised back home in the Naresh Chandra Committee on Corporate Governance as regarding the ‘independence’, or otherwise, of the nominee directors of financial institutions. On one hand, it was felt that since these directors were not functional directors and had no personal interest, as such, in the company, they could be considered to be independent; on the other, it was argued that as representatives of the major creditors, these directors had a particular interest to safeguard, and could hardly be deemed to be independent from the point of view of other stakeholders and minority shareholders. The Committee therefore concluded that nominee directors should not be considered under the category of independent directors.

This issue was also raised in the Narayan Murthy Report on C.G. , the committee report recognized the fact that the institution of nominee directors creates a conflict of interest that should be avoided since such directors often claim that they are answerable only to the institutions they represent and take no responsibility for the company’s management or fiduciary responsibility to other shareholders and for this purpose it is necessary that all directors, whether representing institutions or otherwise, should have the same responsibilities and liabilities. The Report has thus recommended that there shall be no nominee directors and where an institution wishes to appoint a director on the Board, such appointment should be made by the shareholders.

Contradiction

However there seems to exist a direct conflict and contradiction between the SEBI's August 26, 2003 master circular on revision in Clause 49 of the listing agreement and the position that is being proposed under the Companies (Amendment) Bill, 2003.

According to the SEBI's circular, institutional directors on the boards of companies would be counted as independent directors irrespective of whether an institution is an investing institution or a lending institution .

On the other hand, the Companies (Amendment) Bill, 2003 has taken a position that a nominee director or an employee of a financial institution who has offered financial assistance to a company would not qualify to be appointed as an independent director.

All listed entities having a paid-up share capital of Rs 3 crore and above or a net worth of Rs 25 crore or more at any time in the history of the entity are required to comply with the requirements of revised Clause 49 by March 31, 2004.

Moreover the Companies (Amendment) Bill, 2003 provides that a person would not be capable of being appointed as an independent director of a company if he has been a director or an independent director for a consecutive period of nine years or more.

Whereas the latest revision to clause 49 of listing agreement states that a person would be eligible for the office of non-executive director so long as the term of office did not exceed nine years in three terms of three years each, running continuously.

Should Independent Directors be given immunity?

There is growing demand from several quarters that independent directors be given protection from legal proceedings, since it would be very difficult to attract high quality independent directors on the boards of Indian companies if they have to constantly worry about serious criminal liabilities under different Acts . At the same time there is a demand for paying them better remuneration. This creates a contradicting situation in which a person shall be paid more and more for less risk.

While it is agreeable that by virtue of Section 5 of the Indian Companies Act, 1956 the liabilities of executive directors and their non-executive or independent counterparts can not be the same, since it is only when none of these conditions hold that the board in its totality is considered liable as the officer in default under the Companies Act. However it is important to exercise caution that such immunity does not give rise to casualness and carelessness.

One needs to recognize the fact that being a fiduciary, an independent director must be liable for certain explicitly proven acts of omission and commission. For instance, wrongful disclosures by the Chairman and members of the Audit Committee in a company’s annual report should attract disqualification and stringent penalties. Equally, if non-executive directors had knowledge of unlawful acts by the management or the board and, despite such information, failed to act according to law, then they should be certainly legally liable for such infringements.

How much should they be paid?

This is a million dollar question that is begging an answer. If the remuneration is too low, no worthwhile professional or any other person would be willing to spend time on the boards.

Under the present regime, the maximum sitting fee permitted by the Department of Company Affairs (DCA) is Rs.5, 000. It is argued that under such circumstances it is virtually impossible to get independent directors, except from the class of retired people. With such remuneration structures, it shall be very difficult to attract independent directors of the highest standards of skill and probity, which is the need of the day

It has been recommended by the Naresh Chandra Committee on Corporate Governance, that the statutory limit on sitting fees should be reviewed and the matter should be left to the management and the shareholders to decide .

The recently amended Clause 49 of the listing agreement provides that the remuneration of the independent directors should not exceed the amount paid to the executive directors . It is expected that the company management would enjoy high degree of flexibility in fixing remuneration to be paid to the independent directors.

However if the remuneration is too substantial, there is every risk of independence being compromised. Even the Narayana Murthy Committee on Corporate Governance has recognized this conflict by raising the issue as to whether any material benefits from the company other than sitting fees, remuneration, and travel and stay arrangements; which may include stock options and performance bonuses would serve as incentives or hindrances to the objectivity of decision-making and hence, compromise its quality .

As for remuneration to independent directors in loss making companies, the Naresh Chandra committee recommended that these companies should be allowed to pay special fees to such directors, subject to reasonable caps. The committee has emphasized that the loss making companies have a greater need to attract the best independent directors available as such people would be able to help these companies restructure and formulate strategies that ensure its survival .

But the question remains as to will these sick companies be able to afford so many independent directors? And if they don’t pay well, then how would they find good independent directors? , thus making it a vicious circle.

Where would these Directors come from?

With such an important role to perform, the question as to “where would these directors come from?” seems inevitable.

The requirement in India is for a specialized body of senior personnel who possess the requisite skills and attributes and are self-sufficient and economically independent to be able to analyze complex issues and voice their opinions without fear or favour.

One way to address this growing need is to create a new cadre of full-time, but non-executive independent directors, who are remunerated. The basic features of the envisaged system of special, independent directors can be such where the regulator would be responsible to establish and oversee an Institute of Independent Directors. The membership of this institute would be open to directors and top managers of public/private sector companies and civil servants who have attained the age of retirement (typically, 60 years) and to all professionals who have retired from their professional practice, from which the company boards as well as the special directors will have the option to choose each other. Once chosen, the director will be contractually employed by the company for three-five years at the compensation levels set by the institute based on the size and scale of the company and the background of the director.

This will help in building up of a cadre of professional directors who have the necessary expertise in managing companies. Secondly since their position will be secured they will have the independence to voice their opinions objectively. Thirdly, since these directors shall be chosen from a qualified and a diverse pool, it will ensure integration of knowledge of many disciplines thus contributing to the company’s all round growth and development.

Conclusion

There has been a general belief that a personal stake in a business drives one to give his best to it. If one has nothing to lose in the office he holds, as in Government service, there is no sense of belongingness and, therefore, no incentive, no motivating factor for giving good performance, with obviously a few exceptions who shall work with dedication wherever they are posted. The view that the independence of a director can be ensured only if he holds no shares in the company for which he works is yet to be tested.

Moreover, leaving aside a few well known names in corporate sector, most of the other companies may view the appointment of independent directors as a mere legal compliance. It is likely that independent directors will be appointed by the controlling groups in the company, thus defeating the very objective of having independent directors on the board.

Even if all the companies comply with the requirement of having independent directors on the board, there is no guarantee that it would result in better corporate governance. The question remains that will they (boards) be able to prevent scams of the magnitude that we have had before?

This seems unlikely since for it to happen there would have to be general congruence and consistency between the law and the practice, which has never been the case in our country. To cite one example, a circular was issued on February 12, 2003 by SEBI to the Executive Director/Managing Director of all the Stock Exchanges asking them to take more stricter action as it has been observed that in cases where companies listed at the stock exchanges were failing to comply with the various requirements of listing agreement, the exchanges were not initiating any action against the companies .

The object of regulatory law should be to see that working conditions are conducive to honesty and independence but there is no way by which the law can see that one is not exposed to temptations or pressures and thus ensure that one does not succumb to them, since ethics remains out of the four walls of law and law by itself can only offer limited assistance.

Therefore mere provision in law for appointment of independent directors will not really solve all the problems of corporate sector. Ultimately it shall depend on the quality and commitment of persons appointed as independent directors.

Bibliography

Committee Reports

1. Cadbury Committee on Financial aspects of Corporate Governance.

2. The Combined code principles of good governance and code of best practice of the London Stock Exchange

3. Hampel Committee on Corporate Governance,

4. Higgs Committee Report on the role and effectiveness of non-executive directors.

5. International Corporate Governance Network (ICGN) principles of Corporate Governance,

6. Corporate Governance Rule proposals of the New York Stock Exchange,

7. Bouton Report on Corporate Governance in France.

8. The Tyson Report on Development and Recruitment of Non- Executive Directors.

9. The Business Round Table principles of Corporate Governance.

10. Report of the Naresh Chandra Committee on Corporate Audit and Governance.

11. Report of the Kumar Mangalam Birla Committee on Corporate Governance.

12. Report of the Narayana Murthy Committee on Corporate Governance.

Books

13. Ramaiya A, Guide to Company’s Act, (Nagpur: Wadhwa and Company, 15th Edition, Volume 2, 2001)

14. Singh Avtar, Company Law, (Lucknow: Eastern Book Company, 12th Edition, 1999)

Websites

15. www.sebi.gov.in

16. www.dca.nic.in

Statute, Bill, Rules.

17. Indian Companies Act, 1956.

18. The Companies Amendment Bill, 2003.

19. Listing Agreement of SEBI.