Introduction
Recent corporate scams put to question the usefulness of independent directors (IDs). At one end there are IDs who play a minimalist role, on the other there are examples where the IDs had to take the reins of the company in their own hands and run the company. Take the case of Singapore listed Sino Environment Technology Group. The IDs initiated an investigation over suspicious transactions entered into by the management to buy materials and for investments. The investigation initiated by the ID’s revealed that no raw material or equipment was delivered and no significant work was done at the projects the group had invested in. This ultimately led to the resignation of the executive directors (EDs) leaving the running of the company in the hands of the IDs.
The behaviour of the Boards in India generally tends to be between the two extremes, one where ID’s play a ceremonial role and the other where they play a significant role. This article takes a look at various matters relating to IDs, alongside the requirements of clause 49 of the Listing Agreement, the Companies Bill and SEBI’s Consultative Paper on Review of Corporate Governance Norms in India. The annexure at the end of this article also contains a detailed comparison of the above three documents with regard to matters relating to IDs. At the time of writing this article, the rules have neither been notified nor available for public comment and hence the comments with respect to the requirements of the Companies Bill may not be complete.
Can Independence be defined?
Obviously, an ID has to be independent. The next question is independence from what. The independence is from affiliation of any kind which is likely to prejudice his decisions. As can be seen in the annexure, though the goal is to prevent affiliation of any kind, the three documents differ on the details. The Companies Bill goes farther than the SEBI Guidelines in imposing stricter norms for independence which may go a long way in establishing the role of the ID as an “outside guardian”, which investors currently perceive to be a ceremonial position. Nonetheless, it would be fair to say that independence is a state of mind, and can be legislated only up to a point. For example, whilst a relative of a promoter cannot be appointed an ID under the Bill, a friend of the promoter can be appointed as an ID. Appointing a friend instead of a relative, may be far worse from a point of view of independence. Ultimately, it is the ID’s personality and moral compass that will determine his independence. But that does not mean that legislation has no role to play in this matter. The Companies Bill definition provides a sound basis for ensuring that IDs are independent, and that conflict of interest is minimised. Ultimately it is not the law in itself, but a proper implementation of the law and suitable regulatory intervention from time to time, that may firmly establish independence on the Boards. Implementation cannot be replaced by more legislation.
Whose interest does the ID serve?
The normal expectation globally of the role of an ID is essentially two fold; advisory and monitoring. The ID is supposed to contribute his business expertise which could be a good value addition to a company. On the other hand, the IDs are also expected to serve as a watchdog and protect the interest of the minority shareholders. The role of a strategic advisor and a watchdog are not easy to balance and may run at odds with each other at times.
In India, most IDs view their role principally as that of strategic advisors to the promoters. Relatively, most IDs do not perceive their role to be that of a watchdog over the promoters and the management. An ID is not willing to put on the hat of a watchdog because either he or she does not have the necessary time or the skill sets or is not remunerated enough to specifically take on that responsibility. Very often IDs develop close bonding with the promoter group, which makes it difficult for them to ask uncomfortable questions to the Board. But things have changed in recent times due to high profile instances of fraud in India. IDs are taking a direct interest in reviewing the fraud risk management framework put in place by their organisations for mitigating the risk of fraud. For ID’s of global companies, the risk of non-compliance increases significantly due to certain onerous global legislations such as the US Foreign Corrupt Practices Act and the UK Bribery Act.
In countries such as the US and UK, where shareholding in companies is largely public, the IDs can merely take into account shareholder interest as a common factor. However, in countries such as India, where shareholding is concentrated, there would be two factions; the controlling group and the minority shareholders. The controlling group could extract value from minority shareholders through dubious related party transactions or self dealing transactions, for example, through freeze-out mergers, where the controlled company is merged with another company in which the controlling group has a 100% stake. In the case of dispersely held companies, the challenges are different such as restrictions on control contests, shareholder voting procedures, executive compensation and director’s independence from the management. These differences cause the nature of frauds to be different. For example, frauds like Enron and WorldCom where management misrepresents financial performance to cover up poor performance or to influence compensation are more likely in dispersely held companies. Frauds like Satyam and Parmalat where the controlling group covers up expropriation of funds through financial misstatements are more likely in controlled companies.
In the case of controlled companies, even though the IDs may not have the voting power to stop wrongdoings of the controlling shareholder, he or she has the power to make public any wrongdoing. While the controlling shareholder can remove the ID, such actions are likely to cause unwanted public scrutiny. The press may pick up such resignations, but experience tells us that investor’s memory is too short, and other than in a serious fraud such as Satyam, it is unlikely to be an effective tool, though it may relieve the ID from an onerous engagement. Despite the general perception of the public that IDs should act as a watchdog, it appears that given the actual functioning of the Boards, the supremacy of the controlling group and the few Board/Audit committee meetings (assume average of 6 in a year), the watchdog function is not exhaustively performed. IDs argue that they should not be seen as a panacea for everything and a tool to fix all the wrongdoings.
Which of these two groups, the IDs should represent? Clause 166(2) of the Companies Bill requires directors of the company (which includes IDs90) to act in good faith for the benefit of the members as a whole, the company, its employees, the community and the environment. This requirement goes even beyond protecting the interest of the minority and extends to protecting the interest of the general public at large. This provision is far more onerous than it appears at first reading. For example, minority shareholders may argue that the promoters’ decision in favour of an acquisition, caused them huge losses, which the IDs should compensate them for, as they failed to protect the minority interest.
Schedule IV Code for Independent Directors of the Com-panies Bill requires an ID to safeguard the interest of all stakeholders; particularly the minority shareholders. It is a strange irony that IDs appointed by promoters have to protect the interest of the perceived adversaries of the promotersthe minority shareholders. The ID may not have the time, energy, power, gall or the inclination to set things right and in some cases, after exhausting all efforts to discipline the management, the only realistic option available would be to offer his or her resignation. Just because the Bill sets out the responsibilities of the IDs in greater details, does not necessarily mean that IDs will have adequate powers or remunerated commensurately to fulfill those responsibilities.
Liability of an ID
In the aftermath of Satyam, many IDs resigned from their position across India. Whilst some of the resignations may have been a knee-jerk reaction, it is also possible that the IDs were aware of wrong doings by the company which could not be corrected or they were not provided with enough information to make an appropriate judgment on how the company was being run. More importantly, after realising the onerous nature of his assignment he or she was not prepared to take on those responsibilities. The
position of an ID was no longer going to be an easy occupation for those seeking a comfortable retirement occupation.
There are various legislations that can be used against IDs, some of which are criminal violations and may trigger imprisonment. These include:
1. Violation of clause 49 requirements could generate financial and criminal sanction for directors and IDs under the Securities Contract (Regulation) Act 1956; though this has been infrequently targeted against IDs.
2. The Securities and Exchange Board of India (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market) Regulations, 2003, contains various prohibitions on manipulative, fraudulent and unfair trade practices in securities and a prohibition on dealing in securities in a fraudulent manner or using any manipulative or deceptive device in connection with the purchase or sale of securities.
3. Section 12A and 15G of the SEBI Act prohibit insider trading.
4. Section 62 and 63 of the Companies Act 1956, could hold directors liable for certain misstatements in a prospectus to raise capital. SEBI can also impose sanctions for similar violations under the Takeover Code.
5. Under IPC for breach of trust (section 406), theft and cheating (section 420).
6. Under clause 245 of the Companies Bill, a minority group of members or deposit holders can file a class action suit against the directors and claim damages or compensation for any fraudulent, unlawful or wrongful act or omission or conduct.
7. Under clause 447 of the Companies Bill, a director can be imprisoned for a maximum period of 10 years for any fraudulent conduct.
Clause 149(12) of the Companies Bill clarifies that IDs and other non EDs shall be liable only in respect of such acts of omission or commission by a company that had occurred with his or her knowledge, attributable through Board processes, and with the consent or connivance or where he or she had not acted diligently. From this, it appears that the clause seeks to provide immunity to IDs from civil or criminal action in certain cases. However, clause 166(2) of the Bill seems to be a contradiction. It states that the whole Board is required to act in good faith, in order to promote the objects of the company for the benefit of its members as a whole and in the best interest of the company, its employees and shareholders, the community, and for the protection of the environment. This clause narrows the distinction between IDs and EDs, and so does the definition of an “officer in default” under clause 2(60) of the Bill. Whilst an ID is not key managerial personnel under the Bill, he could be an officer in default. An officer in default under clause 2(60) of the Bill is broadly defined, and includes (a) any person in accordance with whose advice, directions or instructions the Board of Directors of the company is accustomed to act, other than a person who gives advice to the Board in a professional capacity; (b) every director, in respect of a contravention of any of the provisions of this Act, who is aware of such contravention by virtue of the receipt by him of any proceedings of the Board or participation in such proceedings without objecting to the same, or where such contravention had taken place with his consent or connivance.
Whilst there is some kind of immunity, for example, in the case of a bounced cheque where the ID can plead that it was done without his knowledge, certain events have sent confusing signals. The Nimesh Kampani and the AMRI hospital fire event in Kolkata where IDs were imprisoned suggest that there may be no immunity to IDs, even when they were not the cause of or responsible for the problem.
IDs operate in an environment of high uncertainty and confusion over their role. They are not clear whether their action or inaction while serving on the Board could subject them to potential imprisonment for violations and frauds committed by the management or the auditors. Many IDs had probably been served arrest warrants arising out of frivolous claims or bouncing of a cheque. This discourages potentially talented candidates from joining as IDs. Clear principles that attempt to replicate some of the fiduciary duty concepts drawn from Delaware law may provide IDs with more comfort that their actions in good faith will not land them up in prison. Directors’ & Officers’ (D&O) insurance is one means to cover IDs for financial liability, but that does not save them from imprisonment.
IDs argue that when a promoter pays a bribe to win a contract, those matters are not escalated to the Board and there is no way an ID would have known about it. To make the ID responsible for such an act would be highly unacceptable. The MCA general circular no. 8/2011 dated 25th March 2011, probably exonerates the IDs in such situations. The circular requires the ROC to exercise due care while including a non ED as an “officer in default”. It specifically states that an ID of a listed entity would not be held liable for any act which occurred without his knowledge or where he acted diligently in the Board process. Whilst these provisions are also contained in the Companies Bill, the exoneration is based on judgment where there is always a scope for interpretation. Besides the Company law, there are several other legislations in India that may cause havoc in the lives of the IDs.
Remuneration of an ID
IDs generally feel that they are inadequately compensated, given the perceived or real risks post the Satyam and Nimesh Kampani episodes. The existing Companies Act requirement (Rule 10B of the Companies (Central Governments) General Rules and Forms, 1956) prescribes sitting fees for independent directors. For companies with a paid up share capital and free reserves of Rs. 10 crore or more or turnover of Rs. 50 crore and above, sitting fees should not exceed the sum of Rs 20,000 and in case of other companies sitting fees should not exceed Rs 10,000. At the time of writing this article, the rules have not yet been framed under the new Companies Bill. In addition to sitting fees, the IDs are also entitled to a profit related commission. The Bill prohibits an ID from receiving stock options. SEBI’s consultative paper has proposed to amend the listing agreement to also prohibit IDs from receiving stock option.
There is overall support to the provision prohibiting an ID from receiving stock options as that directly impeaches his independence. But most people do agree that for the risks that an ID takes, he or she is not commensurately compensated.
Selection of the ID
The appointment of IDs in a controlled company presents unique challenges. The controlling shareholder has majority voting power and can nominate or replace the ID at their discretion. Therefore, the process of hiring and retaining an ID appears to inherently create dependency of the ID on the promoter group. There has been considerable emphasis in India, on whether one should allow minority shareholders to appoint one or more IDs on the Board, though this could be contrary to basic company law principles of one share, one vote. Further, an overzealous ID could become a deterrent, and may end up causing more harm than good to the minority shareholders. An alternative to minority shareholders appointing IDs is to delegate the director nomination process to an independent nominating committee. This practice is already prevalent in many companies in India. The fact that nomination of IDs is directed solely by an independent committee may result in IDs being more independent, than if they were nominated directly by the promoter group.
In the Companies Bill, a listed company may have one director elected by small shareholders. Under clause 178, every listed company and other prescribed class shall constitute a nomination committee. The nomination committee shall identify persons who are qualified to become directors, and recommend them to the Board. Under clause 150, IDs may be selected from a data bank of eligible and willing persons, maintained by a body notified by the Central Government. Thus there are sufficient provisions in the Bill to ensure that the selection process creates greater independence on the Boards.
Rotation of IDs
Sometimes, familiarity breeds complacency. A long tenure may indicate that the IDs have got too friendly with the promoters and over the years have lost their ability to play the role of watchdogs. On the other hand, the longer the ID has been on the company’s Board, he becomes an expert on the company and that industry and his judgment gets better. An ID that is completely new to the company, has less experience, but comes with a fresh pair of eyes and fresh blood. As can be seen, there are pros and con of rotating IDs, and the arguments are not very different from rotating auditors of a company. The Companies Bill requires rotation of IDs, the requirements of which can be seen in the attached annexure. Overall, it appears to be a step in the right direction.
To sum up
The business of life cannot go on if people can’t trust those who are put in a position of trust. However, from the perspective of IDs, there are a number of questions dogging their minds. What are the stakeholders’ and regulators’ expectations from him? How can he fulfill those expectations in the absence of any effective powers? How does he redress the wrong doings? How much trust should be placed on the information presented to him? How much reliance should be placed on experts, such as lawyers, auditors or valuers? What is the extent of due diligence he should carry out? What is the time he should provide to each company where he is an ID? What should be his remuneration? What is he ultimately liable for? Lack of clarity in these areas will only scare away good talent from taking up the position of an ID, and becoming a scapegoat for the misdeeds of management. The Companies Bill with all its good intention to ensure good corporate governance, does not provide any concrete answers to all the above doubts of IDs.
The office of the ID should neither be a bed of roses, nor a bed of thorns. Everyone agrees with that, but there is no agreement on what is the right balance.
