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June 20, 2017

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INDEPENDENT DIRECTORS


- Rudra Pandey, Partner [ Shardul Amarchand Mangaldas & Co ]

rudrapandey

The origins of the concept of independent directors can be traced to the United Kingdom and United States of America. In the United States of America, in the second half of the 20th century, listed companies were encouraged to have at least two ‘outside directors’ on their boards. This was primarily to introduce objectivity to the decision-making process, provide a solution to management-shareholder conflicts, and improve performance of the company. However, corporate scandals like Enron and Worldcom, featuring management transgressions like poor reporting standards, ignorance of high risk issues, unsanctioned loans and guarantees, accounting loopholes, etc. prompted amendments to the listing rules of key stock exchanges like NYSE and NASDAQ.1 These changes also found legislative backing with the enactment of the Sarbanes Oxley Act of 2002, which provided for listed company audit committee independence requirements and responsibilities.

Similarly, following a series of corporate scandals in the United Kingdom, the Cadbury Committee was established in May 1991 by the London Stock Exchange, the Financial Reporting Council and the accountancy profession. The reason for its creation was the significant fall in investor confidence in the accountability of listed companies, which had been triggered, in part, by the Maxwell scandal and the collapse of the Polly Peck consortium and the Bank of Credit.2 The central elements of the Cadbury Report code provided for (i) a clear division of responsibilities, i.e. a separation of the chairman of the board from the chief executive, or a strong independent voice on the board; (ii) the board comprising of a majority of outside directors; (iii) remuneration committees comprising of a majority of non-executive directors; and (iv) the appointment of an audit committee by the board, including at least three nonexecutive directors. These provisions were given statutory authority by amendments to the London Stock Exchange, whereby listed companies had to “comply or explain”, i.e. elucidate the extent of their compliance to the code and explain any deviance from its provisions.3

Developments in India

In India, the origin of independent directors can be traced to recommendations made by the Kumara Mangalam Birla Committee (1999), Naresh Chandra Committee (2002), and Narayana Murthy Committee (2003). Pursuant to these recommendations, the concept of independent director was introduced for the first time by the Securities and Exchange Board of India (“SEBI”) in Clause 49 of the listing agreement, requiring listed entities to appoint independent directors on their board.

With the advent of time, however, the Indian corporate world was shocked by the Satyam scandal, which involved the manipulation of the company’s accounts, amongst other malpractices. Pricewaterhouse Coopers, the independent auditor of Satyam, was fined for not following the code of conduct and accounting standards in the performance of its duties. Immediately after the Satyam scandal in 2009, more than 500 independent directors across various Indian companies resigned due to issues relating to transparency in corporate governance and their consequent liabilities due to fraudulent activities of the companies appointing them.

Subsequently, an order of SEBI in 2011 may have added to the fear in the minds of independent directors. In the said order, three independent directors of Pyramid Saimara Theater Limited were restrained from discharging their duties as directors in any listed company for three years because they had erred in preventing false and misleading accounting disclosures by the company. SEBI, while reiterating the ‘duty of care’ test, refused to accept that directors could not be held responsible for the day-to-day affairs of the company. However, the Ministry of Corporate Affairs (“Ministry”) in a circular in 2011 clarified that penal actions against non-executive directors could only be maintained if the Registrar of Companies (“Registrar”) concluded that the directors had failed to act diligently, and were ‘officers in default’ under the erstwhile Companies Act, 1956. A prosecution against them could not succeed if the violation had occurred without their knowledge or consent. The said circular conferred discretion on the Registrar to confirm and verify the aforesaid factors before issuing a notice to non-executive directors.

The committee constituted by the Ministry to revamp the Companies Act, 1956, was of the view that given the responsibility of the board to balance various interests, the presence of independent directors on the board of a company was critical for improving corporate governance. It also maintained that independent directors would bring an element of objectivity to the board process, working to the benefit of general interests of the company and those of the minority and smaller shareholders. Accordingly, the requirement of independent directors was proposed by means of the Companies Bill, 2009 (“Bill”). The Bill provided for independent directors to be appointed on the boards of companies along with attributes determining independence.4

Independent directors under the Companies Act, 2013 (“Act”) and SEBI regime

The committee constituted by the Ministry to revamp the Companies Act, 1956, was of the view that given the responsibility of the board to balance various interests, the presence of independent directors on the board of a company was critical to improving corporate governance

These proposals were incorporated in the Act, which mandates the appointment of independent directors by all public listed entities and certain prescribed classes of public companies. A concomitant obligation on listed entities is captured under the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (“Listing Regulations”). The number of independent directors mandated thereunder ranges from a minimum of 1/3rd to 1/2 of the board, based on the board constitution. The Act (along with the Listing Regulations) prescribes the pre-requisites of being an independent director.

An independent director is a director other than a managing director, a whole time director or nominee director who, amongst others, is a person of integrity and possesses relevant expertise and experience; is not or was not a promoter of the listed entity, or its holding, subsidiary or associate company; is not related to the promoters or directors of the company, its holding, subsidiary or associate company; and has had no pecuniary relationship with the company or its promoters or directors during the immediately preceding two financial years. An independent director must possess appropriate skills, experience and knowledge in fields like finance, law, management, corporate governance, etc., related to the company’s business. An independent director is also required to be a part of various committees of the board, such as the nomination and remuneration committee, audit committee and corporate social responsibility committee. Independent director must comply with the code of conduct for independent directors provided in Schedule IV of the Act, which lays down guidelines for their professional conduct. These revolve largely around protecting the interests of the company, its shareholders and employees, reporting concerns about any violations, etc., maintaining their own ‘independence’ and objectivity at all times, and assisting the company in implementing the best corporate governance practices.

In today’s context, independent directors are involved in the review of, among others, the performance of the (i) management; (ii) board; (iii) non-independent directors; and (iv) chairperson of the company (taking into account the views of executive and non-executive directors). Importantly, the Act limits the liability of an independent director to such acts of omission or commission by a company which had occurred with his knowledge, attributable through board processes, and with his consent and connivance or where he had not acted diligently.

Conclusion

The aforementioned developments have made it evident that the role of the independent director is considered pivotal to the company’s growth and effective management. While the legislature has indeed taken steps in a positive direction, the determining factors in making this exercise a successful one will be (i) the company’s role in satisfying itself of the capabilities and independence of its independent directors; (ii) the role of the independent directors in scrutinizing the affairs of the company with a keen eye, and continually ensuring their own independence; and finally (iii) functions of the board being guided by honesty, frequent introspection and integrity. Only when these steps are implemented in congruence with each other can high standards of corporate governance be truly achieved.

Footnote:
1. Seil Kim and April Klein, “Did the 1999 NYSE and NASDAQ Listing Standard Changes on Audit Committee Composition Benefit Investors?” (January 2017), available at , last viewed on May 12, 2017.
2. Anonymous, “The Cadbury Report”, the University of Cambridge (Judge Business School), available at , last viewed on May 12, 2017; see also Ranjan R., “Role of Independent Directors in Corporate Governance”, Indian Academy of Law and Management, available at, last viewed on May 12, 2017; see also Donald C. Clarke, “Three Concepts of the Independent Director”, George Washington University School of Law, 32 Del. J. Corp. L. 73 (2007), available at , last viewed on May 12, 2017.
3. Anonymous, “The Cadbury Report”,the University of Cambridge (Judge Business School), available at , last viewed on May 12, 2017.
4. The Companies Bill, 2009, available at , p. 68, last viewed on May 12, 2017

Disclaimer – The views expressed in this article are the personal views of the author and are purely informative in nature.

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