ROLE OF INDEPENDENT DIRECTORS

If there is
one institution that has been seen as a panacea for all ills in corporate
India, it is that of independent directors. The role of the independent
directors has come to mean different things to different people. Like the story
of the blind men and the elephant, it has come to mean different things
to different people. Some believe the independent director to be a strategic
guide; others want her to be a conscience-keeper; while yet others believe she
is a policewoman, who some believe is a watchdog and others believe must be a
bloodhound.

First, a word
on what exactly a director, or for that matter, the Board of Directors is meant
to do. Directors are those who direct the running of the company. The Board of
Directors comprises the individuals who direct the course of operations. The
management conducts the affairs of the company under the overall
superintendence, oversight and control by the Board of Directors. The
management of a company holds office at the pleasure of the Board of Directors.
Directors of a company hold office at the pleasure of the shareholders of the
company.

Once the Board
of Directors is appointed, the shareholders move out of the picture in relation
to the day-to-day oversight of the company. It is for the directors to govern
the company in terms of the Articles of Association. It is the directors who
are meant to provide strategic direction and guidance to the management of a
company. That is their main role. An attendant consequence is the role of being
policemen keeping vigil over the conduct of affairs by the management.  

In this
context, sits the office of independent directors, which is now firmly codified
into the law. Making its debut in the Listing Agreement – a statutory agreement
between listed companies and stock exchanges – the concept has moved firmly
into Parliament-made company law, and indeed in the SEBI (Listing Obligations
and Disclosure Requirements) Regulations, 2015 (“LODR Regulations”)
governing listing obligations that has replaced the listing agreement. With
each move in this regulatory waltz, the expectation, role and scope of what is
expected from an independent director has kept changing. Add to this rulings by
courts that have at the least laid down what cannot be ruled out from the role
of these directors. 

Independence from?

Yet, to begin
with, one has to necessarily understand what the law expects from independent
directors in terms of independence – are they meant to be independent of
ownership or are they meant to be independent from management? As defined, the
independence is expected from both ownership and management. The definition
rules out independence of a director on both counts. An equity ownership
interest of two percent or more would result in a director being regarded as
non-independent. Likewise, senior executives of a company who become directors
would not be considered independent unless three years have passed since their
association with the company. 

However, the
facet that skews the picture in any case is that all independent directors
would in any case rely on the vote of all shareholders to be appointed to the
Board of Directors – just as any other director would have to be voted into
office. In other words, every director, including the independent director,
holds office at the pleasure of the majority vote of the shareholders. 

How
independent can the director therefore be, purely as a matter of political
science, from the shareholder? The answer perhaps does not lie in making the
majority owners, or controlling owners (under Indian law, “promoters”)
ineligible to vote for independent director appointments.  The answer in fact lies in recognising that
independent directors cannot be totally independent of ownership and can indeed
lose their office by being voted out for being unpopular. Therefore,
strengthening the institution of the independent director, granting an
independent director protection of tenure, and providing conceptual clarity on
real role expectations is the way to go.

The very
concept of independent director is one that has developed as a matter of best
practice elsewhere in the world, but has been codified into the law here. Best
practices that evolved with the aim of minimising the risk of litigation
against those involved in governance of companies as a shield against
litigation, have become swords that directors need to defend themselves
against.

Role of
Independent Directors

The question
of whether a director is meant to represent the interests of the shareholders
has been well settled in case law. 
Company law is quite clear that the role of every director on the Board
of Directors, whether independent or not, is to apply her mind to serving the
best interests of the company, and not of the shareholder who nominated her to
be appointed. Indian company law has been codified for long. However, what
standards a director must bring to bear, how she is supposed to conduct herself
in decision-making, and what is a realistic expectation from her was left
substantially to the sphere of judge-made law, laid down when dealing with
controversies and proceedings presented to them for resolution. India is a
common-law jurisdiction – gaps in the statute are filled in by judges,
providing meaning to ambiguities and inconsistencies based on the principles of
justice, equity and good conscience. 

Some of these
principles are now codified into the Companies Act, 2013 (“the Act”), with
section 166¹ , which contains motherhood statements in the
expectations from directors in general, leaving the burden of establishing the
tests and standards to be applied when ruling on alleged violation of the
provision, to the courts – but more about that later. Once appointed, a
director has a fiduciary duty to discharge to the company and she is not a
servant of the shareholders who appoint her. The shareholders cannot impinge
upon the exercise of rights by a director in discharge of the fiduciary duties
of the director. Shareholders cannot dictate terms to directors except by
amendment of Articles of Association or by sacking the directors². 

In the words
of the court, in the first-cited judgement in the footnote to the foregoing
paragraph:-

“The
shareholder….. is entitled to consider his own interests, without regard to
interests of other shareholders. However, Directors are fiduciaries of the
Company and the shareholders. It is their duty to do what they consider best in
the interests of the Company. They cannot abdicate their independent judgment
by entering into pooling agreements.”

_______________________________________________

1   References to Sections
by number are references to provisions of the Companies Act, 2013 while
references to Regulations by number are references to provisions of the SEBI
(Disclosure Obligations and Listing Requirements) Regulations, 2015.

2              All these principles are well
stated by a Division Bench of the Hon’ble Bombay High Court in the case of
Rolta India Ltd. & Another Vs. Venire Industries Ltd. & Others 2000
(100) Comp. Cas. 19 (Bom) and has been well analysed in other decisions
applying the principles found in this judgement, including Mrs. Madhu Ashok
Kapur & 3 Others Vs. Mr. Rana Kapoor & 8 Others – decision by Justice
Gautam Patel of the same court on June 4, 2015  
           

“In our view,
the curtailment of the powers of Director by enforcement of such a clause would
not be permissible. Clause 8 would result in curtailment of the fiduciary
rights and duties of the Directors. The shareholders cannot infringe upon
the Directors’ fiduciary rights and duties. Even Directors cannot enter
into an agreement, thereby agreeing not to increase the number of Directors
when there is no such restriction in the Articles of Association. The shareholders
cannot dictate the terms to the Directors, except by amendment of Articles of
Association or by removal of Directors.”

[Emphasis
Supplied]

In the second
judgement referred to in the footnote to the foregoing paragraph, the court
rejected the attempt to cite the aforesaid judgment to support arguments
relating to the facts of the case before the court, but well reiterated the
same principle thus: –

“Or take a
nominee director, that is, a director of a company who is nominated by a
large shareholder to represent his interests. There is nothing wrong
in it. It is done every day. Nothing wrong, that is, so long as the director
is left free to exercise his best judgment in the interests of the company
which he serves. But if he is put upon terms that he is bound to act in
the affairs of the company in accordance with the directions of his patron, it
is beyond doubt unlawful, or if he agrees to subordinate the interests of
the company to the interests of his patron, it is conduct oppressive to the
other shareholders for which the patron can be brought to book .”

[Emphasis
Supplied]

The
codification of directors’ responsibilities in section 166, is a game-changer
in what company law means for directors. 
For independent directors, the Code of Conduct stipulated u/s. 149 read
with Schedule IV, is another game changer. These are now explicit provisions of
the law that require directors to be mindful that their constituents are way
beyond shareholders alone. For all directors, the term used is “stakeholders”
u/s. 166 while for independent directors, there are specific obligations
imposed to be mindful of the interests of minority shareholders. 

Therefore,
many of the past practices and comfort zones reached by corporate Boards of
Directors, are up for disruption. The impunity that has been demonstrated in
the past is no longer a light matter – indeed, companies are now actively
considering becoming private limited companies so that they are not bound by
the statutory obligation of maintaining the institution of independent
directors. A case in point is Tata Sons Ltd., which is a “systemically
important core investment company” and has sought to convert itself into a
private limited company amidst litigation over governance standards applied in
that company⁴.

What is clear
is that independent directors can now be litigated against as a matter of
codified legal standard, with principles-based law that forms part of statutory
obligations set out in Schedule IV of the Act.

Limitation of
Liability

Now, one facet
of the law that is not fully appreciated among Indian corporate boards yet, is
that while the limitation of liability for shareholders is limited,
increasingly, the limitation of liability for directors seems to not be so. The
Act has codified the obligation to have independent directors⁴;  the qualifications of an independent director⁵;
the duties of independent directors⁶, with a specially stipulated
Code of Conduct for independent directors⁷. A fully codified robust
statutory framework for governance of companies in India is now formally in
place.

It is settled
law that every director of any company (including directors nominated by
specific shareholders) are meant to address and look after the interests of the
company and not the interests of the shareholders nominating them.

A director
indeed holds office at the pleasure of the shareholders, who can appoint,
remove or replace a director in compliance with other applicable law, by
passing an ordinary resolution. This is in fact the reason for the Takeover
Regulations to provide that a right to appoint a majority of the Board of
Directors constitutes “control” and it is the shareholder holding the majority
of a company who is deemed to be acquiring the voting rights in any listed
company, held by the company being acquired.

A ruling by
the Hon’ble Supreme Court just before the onset of the Act and the LODR
Regulations is instructive in appreciating this growing trend in this area of
jurisprudence.  Upholding monetary
penalty imposed against directors of a company for a finding of market abuse by
a company, in the case of N. Narayanan vs. Adjudicating Officer, SEBI⁸
the Court actually ruled that the role of directors in listed companies is
meant to be a “particularly onerous” one, stating that “the Board of Directors
makes itself accountable for the performance of the company to shareholders and
also for the production of its accounts and financial statements especially when
the company is a listed company.” 

_________________________________________________________________

3   Disclosure: The author is involved as an advocate
in the litigation and is interested in the intervention against Tata Sons Ltd.

4   Section 149(4)

5   Section 149(6)

6   Section 149(8) read with Schedule IV

7   Schedule IV to the Act

8 Civil
Appeals no. 4112 – 4113 of 2013 – available at:
http://judis.nic.in/supremecourt/imgs1.aspx?filename=40338

In the court’s
own words (paraphrasing would not do justice to the content): –

Responsibility
is cast on the Directors to prepare the annual records and reports and those
accounts should reflect ‘a true and fair view’. The over-riding obligation of
the Directors is to approve the accounts only if they are satisfied that they
give true and fair view of the profits or loss for the relevant period and the
correct financial position of the company. Company though a legal entity cannot
act by itself, it can act only through its Directors. They are expected to
exercise their power on behalf of the company with utmost care, skill and
diligence. This Court while describing what is the duty of a Director of a
company held in Official Liquidator vs. P.A. Tendolkar (1973) 1 SCC 602
that a Director may be shown to be placed and to have been so closely and so
long associated personally with the management of the company that he
will be deemed to be not merely cognizant of but liable for fraud in the
conduct of business of the company even though no specific act of dishonesty is
proved against him personally. He cannot shut his eyes to what must be
obvious to everyone who examines the affairs of the company even superficially.

The facts in
this case clearly reveal that the Directors of the company in question had
failed in their duty to exercise due care and diligence and allowed the company
to fabricate the figures and make false disclosures. Facts indicate that they have overlooked the numerous red flags in the
revenues, profits, receivables, deposits etc. which should not have escaped the
attention of a prudent person. For instance, profit as on quarter ending June
2007 was three times more than the preceding quarter, it doubled in the quarter
ending December 2007 over the preceding quarter. Further, there was
disproportionate increase in the security deposits i.e. Rs. 36.05 crore in
September 2007 to Rs. 270.38 crore in December 2007 as compared to increase in
the number of theatres during the same period. They have participated in
the board meetings and were privy to those commissions and omissions.

[Emphasis
Supplied]

All the
judgements and precedents cited above involved the law governing directors and
their role prior to the Act and the LODR Regulations coming into force. Now,
the codified law stipulates the standards to be followed and expectations from
directors.  To take just the role of
independent directors, summarising and paraphrasing just some of their
obligations under Schedule IV, such directors must: –

a)  act objectively, constructively and exercise
responsibilities in the interest of the company;

b) not allow extraneous considerations to vitiate
objective independent judgment in the paramount interest of the company as a
whole;

c)  bring independent judgment to bear on the
Board’s deliberations especially on issues of strategy, performance, risk
management and resources;

d) safeguard the interests of all stakeholders,
particularly the minority shareholders;

e)  balance conflicting interests of the
stakeholders;

f)  moderate and arbitrate in the interest of the
company as a whole;

g) seek appropriate clarification or amplification
of information and, where necessary, take and follow appropriate professional
advice and opinion of outside experts at the expense of the company;

h)  ensure that concerns about any proposed action
are addressed and, to the extent that they are not resolved, insist that their
concerns are recorded;

i)   ensure adequate deliberations before
approving related party transactions and assure themselves that the same are in
the interest of the company; and

j)   hold meetings of just the independent
directors at least once in a year, without the attendance of non-independent
directors and members of management.

Each of these
standards would necessarily entail mixed questions of fact and law in disputes
involving interpretation of Schedule IV. Section 166 is but a synopsis of these
tests and is made applicable to all directors, whether or not independent. The
LODR Regulations, which follow more of a check-the-box framework for
composition of the Board of Directors and of sub-committees of the Board of
Directors or listed companies, too have to be read with Section 166.  It must be remembered that the provisions of
the SEBI Act, in particular, sections 11 and 11B, entitle SEBI to issue
directions “in the interests of the securities market”. Such directions may be
issued by SEBI of its own accord without having to convince any independent
judicial mind about the appropriateness of its intervention.  The only check and balance is a post-facto
statutory appeal to the Securities Appellate Tribunal.

This poses
multiple nuanced threats to directors. Actions may be taken suo motu by
SEBI where it is convinced that a director must be taught a lesson. These may
take the form of restraint not to deal in securities or not to join the board
of directors of other listed companies or capital market intermediaries for
specified periods.  Action by SEBI could
be triggered by a complaint by other regulatory agencies and tax authorities.
There is precedent of regulatory action triggered in such a manner.  It is only a matter of time for the gravity
and creativity in the application of the law to reach the doorstep of
independent directors of companies that SEBI acts against.

Some independent directors are also prone to
getting carried away and get involved in the day-to-day functioning of the
company – at times with direct access to the employees whose line of reporting
is to the CEO.  Whether a director has
been truly in charge of day-to-day operations or only relied on Board processes
for oversight of the company, will always be a mixed question of fact and law,
requiring tedious evidence.

Given the
scope for intervention by the securities regulator and indeed other regulators
who may be regulating the company in question, one must be very clear and have
very specific and formal processes for an independent director’s engagement
with the company.