INDEPENDENT DIRECTORS UNDER THE COMPANIES BIL, 2012

— Leo Tolstoy

Introduction

 Leo
Tolstoy captures the essence of independent thinking and maybe, it is
this essence which led companies across the globe to adopt and
incorporate the concept of appointment of independent directors on their
Boards. This concept was first introduced in the United States of
America and slowly spread across the globe, both in developed and
developing countries. The recent Companies Bill, 2012 (Bill) has made an
attempt to match the current global standard vis-à-vis appointment and
role of independent directors. This article makes an attempt to briefly
discuss the provisions relating to independent directors in the Bill and
provide a perspective on the laudatory efforts as well as the
shortcomings of the provisions.

Brief history of independent directors in India

The
importance and role of independent directors in the Indian scenario was
brought to the forefront by the Kumarmangalam Birla Committee (KBC) in
the year 1999. The recommendations of the KBC Report lead to the
introduction of Clause 49 of the Listing Agreement (which deals with
appointment and role of independent directors of listed companies) by
the Securities and Exchange Board of India (SEBI) in the year 2000.
Subsequently in 2003, another committee chaired by Mr. Narayan Murthy
suggested further changes to Clause 49 of the Listing Agreement and the
current clause is mostly based on the recommendations made by the
Narayan Murthy Committee (NMC). Another committee set up by the Ministry
of Corporate Affairs called the JJ Irani Committee in 2005 further
recommended certain changes contrary to those suggested by the NMC,
which were incorporated in the previous bills introduced in the
Parliament, in an attempt to replace the Companies Act, 1956 (Act).
Unfortunately, the Companies Bill, 2009 was not approved by the
Parliament and therefore, another attempt has been made to replace the
Act in 2012. In the meanwhile, the Ministry of Corporate Affairs had
also introduced some voluntary guidelines in 2009 relating to
independent directors, but since it did not have any binding effect,
many of these guidelines are not being followed by most of the
companies.

Companies Bill, 2012

Whilst a detailed
comprehensive analysis of all the provisions in the Bill relating to
independent directors is beyond the scope of this article, an effort has
been made to highlight some of the important provisions and discuss
their implications.

Qualifications and Neutrality

The
Bill has prescribed detailed qualification criteria for independent
directors, which were not set out in so much detail in the Listing
Agreement. It is evident from the provisions in the Bill regarding
independent directors that much emphasis has been placed on ensuring
complete independence of independent directors. The effect of these
provisions is to ensure that an independent director has neither any
relationship with or any interest in the company and/or its group
companies, nor is he incentivised by them in any manner, which may lead
to bias in favour of the company where he is so appointed. Certain
criteria which a person must satisfy in order to be eligible for
appointment as an independent director have been discussed below.

An
existing or past promoter, key managerial personnel, or employee of the
company or its holding/ subsidiary/ associate companies (Group
Companies) cannot be an independent director. Despite the wide
definition of associate companies, an argument may be made that this
restriction is reasonable, since promoters, key managerial personnel and
employees of these associate companies may have vested interests in the
company. However, the Bill also prohibits relatives of promoters and
directors of the company or it’s Group Companies from being independent
directors. Further, persons whose relatives are key managerial persons
or employees of the company or its Group Companies are also not
permitted to be independent directors. Considering the broad scope of
the definitions of the terms “relative” and “associate company”, the
list of people who are barred from being independent directors in listed
companies may become huge, especially if the group structure is
multilayered or complicated.

Another restriction in the Bill is
that the independent director, along with his relatives, may not hold
more than 2 % of the voting power of the company. It is not clear
whether indirect holdings (through companies controlled by the
director/relatives) would be aggregated or only direct holdings would be
considered for this purpose. In case of the former, identification of
all such entities/persons and verification of their shareholding in the
company would be an extremely tedious process and may lead to an
enormous work overload for the compliance/ secretarial teams.

An
independent director must not have had “any pecuniary relationship”
with the company, its Group Companies, or their promoters or directors
for a period of two years prior to appointment, or during his term. This
provision is significantly more restrictive than the requirements under
the Listing Agreement at present, which state that an independent
director must not have any material pecuniary relationship or
transaction, which could affect his independence. Therefore, minor
transactions and pecuniary relationships between the company and an
independent director currently do not disqualify him. The proposed ban
on any pecuniary relationship for independent directors in the Bill may
be unreasonably restrictive, as there are situations where a transaction
or relationship of the director may safely be considered to be of a
nature which cannot affect the director’s independence. For example, a
proposed director may have a standard fixed deposit with a banking
company, on the rates applicable to the general public, which may be
ordinarily considered to be a perfectly mundane and ordinary transaction
which cannot possibly lead to any bias. However, this would be
considered to be a pecuniary relationship with the banking company and
would prevent the person from being appointed as an independent
director. Also, the broad definition of the term “associate company”
further exacerbates the restrictive nature of the provision, which
prohibits pecuniary relationships with such companies as well as their
promoters and directors. A proposed independent director may have some
on-going transactions with a director of an associate company, which may
not contribute significantly to the director’s income, and even
otherwise, may not be very significant for him. However, due to the
provisions of the Bill, which prohibit “any pecuniary relationship”,
such a person is disqualified from being appointed as an independent
director.

Several other restrictions have been built into the
Bill to ensure that there is no financial nexus between the independent
director and the company. For example, the Bill prohibits independent
directors from receiving stock options of the company. This is also a
change from the provisions of Clause 49 of the Listing Agreement, read
with relevant SEBI regulations, under which independent directors are
presently allowed to hold stock options in the company. Apart from the
restriction on stock options, the remuneration of independent directors
has also been limited to sitting fees, reimbursement of expenses for
participation in the Board and other meetings and profit related
commission as may be approved by the shareholders. Independent directors
also cannot be the chief executive or director or hold any other
similar position in any nonprofit organisation that receives twenty-five
percent or more of its receipts from the company, its promoters,
directors, Group Company or that holds two percent or more of the voting
rights of the company.

The fact that nominee directors are
excluded from being independent directors is another example of the
emphasis placed by the Bill on ensuring absolute neutrality of the
independent director. Under the Listing Agreement, nominee directors of
lenders/investors are deemed to be independent directors. However, the
Bill also expands the scope of the term ‘nominee director’ to mean any
director nominated by “any financial institution in pursuance of the
provisions of any law for the time being in force, or of any agreement,
or appointed by any Government, or any other person to represent its
interests”, and states that all such nominee directors may not be
classified as independent directors. It is true that a nominee director
may only be concerned about the decisions of the company which may
affect the interests of the entity/person who has nominated him.
Considering that, it may not be proper to deem such a director to be an
independent director, since the very nature of his position indicates
that he would put the interests of the nominating entity above the
interests of the company. Therefore, in this regard, the changes
introduced by the Bill may be considered necessary and appropriate.

Process of appointment and due diligence
The
Bill mandates that prospective independent directors may be selected
from databanks maintained by institutions to be notified by the ?entral
Government. It is not clear on what basis would people be permitted to
register themselves in this database, although the Bill states that
rules would be prescribed for maintenance of such databases. Further,
the Bill provides that the terms of appointment of an independent
director must be approved by a resolution of the shareholders.

The
Code for Independent Directors in Schedule IV of the Bill (Code) also
prescribes that the terms of appointment of the director must be
formalised through a letter of appointment that inter alia sets out the
fiduciary duties that come with such an appointment along with
accompanying liabilities. The concept of “fiduciary duty” being a broad
and subjective one, it is not clear what duties and liabilities would
have to be set out in the appointment letter. Further, it is also not
clear whether these fiduciary duties are in addition to the duties of
directors already prescribed under Clause 166 of the Bill, which are by
themselves quite burdensome and broad in scope. The fact that several
subjectively worded fiduciary duties have to be reduced to writing in
their appointment letter would not be a very appealing prospect for
independent directors.

The Bill further states that the company
is responsible for conducting due diligence on the candidate to ensure
that such person is not disqualified from being an independent director,
thus putting the onus for selection of a fit and proper person on the
company. There are two aspects to this due diligence exercise that
companies will have to conduct. Firstly, they would have to check
internally and with Group Companies regarding matters such as the
candidate’s shareholding, employment or association with them. This
aspect of the due diligence may be relatively simpler. However, to do a
complete diligence on the candidate, the provisions of the Bill require
the company to source information from several external entities and
sources. Listed companies must identify each auditing, consulting and
legal firm in which the proposed independent director is or was an
employee, or partner or proprietor of, and then ensure that such firms
have had no relationship with the company or its Group Companies.
Further, a comprehensive list of the relatives of the independent
directors, and all companies and other entities controlled by them would
have to be prepared and it must be verified that none of them hold more
than 2% of the share capital of the company, or its Group Companies or
have pecuniary relationships with such companies which go beyond the
prescribed thresholds in the Bill.

It is obvious that these
background checking and verification procedures would be extremely
onerous, resource-intensive and time-consuming for any company to carry
out.

The provisions of the Bill are unclear on whether listed
companies are required to constantly verify on an ongoing basis that the
independent director does not fall afoul of the prescribed criteria.
The Bill merely states that company must conduct the due diligence on a
proposed independent director “before appointment” of such director.
However, the provisions of Clause 149 (8), which state that the company
and independent director must comply with the Code, read with the terms
of the Code itself, may be interpreted to mean that the company and the
director are jointly and severally responsible for ensuring that the
independent director is not disqualified. This view may lead to several
absurd situations, where the company may be held responsible and
penalised for events entirely beyond its control. For instance, an
associate company, over whose decisions or actions a company may not
have control, may appoint a firm of auditors where an independent
director of the concerned company is a partner, thus disqualifying him
from being an independent director. In the ordinary course today, a
company may not even be aware of the auditors of its associate
companies, but the provisions of the Bill may require it to constantly
monitor such matters completely irrelevant to its business for the
purposes of ensuring compliance.

Participation

Certain
provisions of the Bill are aimed at preventing situations existing
presently, where independent directors are often appointed by companies
merely to be a rubber stamp for decisions taken by the Board. One such
provision is the mandatory presence of independent director on a number
of committees of listed companies. One third of the audit committee,
half of the nomination and remuneration committee, and at least one
member of the newly conceptualised corporate social responsibility
committee, must be independent directors.

The Code prescribes
that independent directors are required to hold at least one meeting
each year, without the attendance of non-independent directors and
members of management. In such meetings the independent directors shall
review the performance of the other directors, the Chairman and the
Board as a whole and asses the information flow between the management
and the Board. While there is no obligation on the Board to accept any
recommendations which may emerge from such a meeting, this provision is
welcome as it encourages discussion among the independent directors and
greater awareness of and participation in the functioning of the Board.
Another example of provisions encouraging participation by independent
directors is relating to Board meeting notices. The Bill provides that
Board meetings may be called by notice shorter than seven days only if
at least one independent director (if any) on the Board is present at
such meeting.

With regard to the composition of the Board, the
Bill mandates that one third of the Board of listed companies is
required to be independent directors. It may be pertinent to note that
this obligation is actually less strict than the one currently imposed
by the Listing Agreement, where if the Chairman of a listed company is
an executive director, half of the Board is required to be independent
directors. Finally, the re-appointment of independent directors is
required to be made on the basis of a report of performance evaluation
by the Board. However, the manner and criteria for such evaluation has
not been prescribed in detail.

The aggregate effect of the above
mentioned provisions would hopefully put a stop to the phenomenon of
token independent directors who are appointed by companies merely for
compliance with the Listing Agreement provisions, and who are
essentially proxies for the promoters.

Rotation

As
per the Bill, independent directors are not subject to the annual
rotation procedure applicable to other directors on the Board. They are
permitted to have a term of five years, with a limit of two consecutive
terms. After two such terms, a mandatory break of three years is
prescribed, during which the director again must not have any
association with the concerned company. It appears that the five year
term and exclusion from annual rotation is intended to protect
independent directors and prevent promoters and major shareholders from
forcing retirement onto directors who do not toe the line. Nevertheless,
it does not mean that a non-performing and non-cooperative independent
director can be complacent about his position, as his re-appointment by
the members is subject to the results of a performance evaluation, as
mentioned above. However, on Boards where the majority of directors are
independent, provisions relating to compulsory rotation and fixed term
may prove to be an issue, as the executive directors may need to retire
to meet the quota of directors required to retire by rotation.

Analysis

Upon a reading of the above, it is evident that:

•    There is an expectation that there will be an increased level of active participation by independent directors;

•   
The duties of independent directors are quite onerous, and in certain
cases, rather ill-defined and vague, such as the wide and subjective
nature of the Code;

•    The terms of appointment and penal
consequences for non-compliance with fiduciary duties are reduced to
writing in the terms of appointment of the independent director;

•   
Independent directors are required to constantly monitor their
relationships and transactions, including those of their relatives and
related entities in order to ensure that they don’t fall afoul of the
prescribed qualifications; and

•    There are several
restrictions on the remuneration allowed to be provided to independent
directors, including a prohibition on stock options.

Apart from
the fact that companies are required to test persons against all the
criteria laid down in the Bill to ensure that they qualify as
‘independent directors’, it will be difficult to convince people to
become independent directors on the Boards of companies in light of the
stringent and onerous responsibilities, duties and penalties listed
above. These harsh and inflexible provisions will deter people from
becoming independent directors, creating a scarcity of persons
interested in being appointed on Boards as independent directors.

Conclusion

While
the provisions of the Bill regarding independent directors may have
been drafted with noble and laudable intentions, it is evident that
compliance with such a restrictive regime would prove to be a nightmare
for companies. Indeed, as set out above, in certain situations
compliance may be impossible. The move towards a corporate governance
environment where independent directors are neutral and ‘independent’ in
the true sense of the term, is an effort which needs to be appreciated.
However, the provisions require a fair amount of tweaking in order to
ensure that they are effective without being unduly onerous or in some
cases impossible to achieve.