Role of Independent Directors in Corporate Governance
The concept of Independent Directors (ID’s) have gained a world wide momentum in the wake of Corporate Governance in recent years with the advent of various corporate failures such as Satyam Debacle, Enron Debacle, and several other scandals. Corporate Experts have always felt the need for the directors to be independent and free from the influence of the Board. The demand made by the experts was relevant because directors are appointed by the board itself which in turn is under the control of the Chief Executive Officer who also happens to be the Chairman of the Board. In reality Directors in many companies do not have any say even when there is a need for their approval.
But unfortunately the legislators in several countries have understood the significance of Independent Directors only after the emergence of various scams, that triggered the world economy. It is often observed that the presence of Independent Directors have hailed as an effective detterent against fraud, mismanagement, inefficient use of resources, inequality, unaccountability of decisions and as a harbinger for striking the right balance between individual, economic and social interests.
This article focuses on the need for Independent Directors and their role in Corporate Governance in the national and international context. It provides a good opportunity to the readers for understanding the concept of Independent Directors and their role in Corporate Governance at the grass root level and taking stock of the present scenario prevailing in India. The article is divided into 10 segments. Segment 1 traces the evolution and the genesis of Independent Directors. Segment 3 defines Independent Directors. Segment 4 examines the question as to What constitutes Independent Directors? Segment 5 describes Independence as an ongoing requirement. Segment 6 describes the Board Composition. Segment 7 describes the rationale behind the concept of Independent Director 8 emphasises the Need For Independent Directors. Segment 9 portrays the Role of Independent Directors in Corporate Governance. Segment 10 deals with the Code for Independent Directors. Segment 11 outlines the Duties of Independent Director. Segment 12 throws light on the Qualifications of an Independent Director. Segment 13 talks about the manner of appointment of Independent Directors. Segment 14 deals with the Resignation or Removal of Independent Directors.
I. EVOLUTION OF INDEPENDENT DIRECTORS
The concept of Independent Directors emerged in the US in the 1950’s. The general notion of the American Boardroom Practice was that Independent Directors used to serve as a solution to the Manager-Share Holder Agency problem. Independent Directors was introduced as a voluntary mechanism in the US with the belief that a board with some level of independence will introduce objectivity in decision making, add to the diversity and advisory capabilities of the Board and hence improve performance of the company. Later various arms of the government accepted this idea in a phased manner.
What commenced as a voluntary movement in the 1950’s took on a mandatory form following the various corporate governance scandals such as Enron, World Com, Tyco and the like that occurred at the turn of the century and resulted in the enactment of stringent legislation in the form of Sarbanes Oxley Act in the year 2002 and amendments to the listing rules of key stock exchanges such as NYSE and NASDAQ(2*).
Similar changes occurred in the UK too, with the advent of Maxwell and Polly Peck scams which triggered the country and kindled the minds of the Corporate Experts to bring about sweeping reforms in the corporate governance structure prevailing at that time. This led to the constitution of various committees headed by a corporate expert. The first committee to be established in this regard is the Cadbury Committee(3*). It aimed at reporting on the financial aspects of corporate governance.
Later in the year 1995 Greenbury Committee(4*) was established and it dealt with a contentious aspect of corporate governance which is the pay of the executives in the company. The committees main aim was to identify good practice in determining Directors Remuneration and prepare a code of such practice for use by UK PLC’s.
Further in the year 2003 although substantial improvements in corporate governance had been stimulated in UK listed companies certain areas have been highlighted for further improvements by the Higgs Committee(5*). In the same year the UK Government in response to the Enron scandal commissioned a committee known as the Smith Committee(6*) which passed its report known as the Smith Report.
The origin of Independent Directors under the existing corporate law regime in India can be traced to the recommendations made by the Kumara Mangalam Birla Committee (1999), Naresh Chandra Committee (2002), Narayana Murthy Committee(2003). Further to these proposals the term Independent Director was introduced for the first time in India when the Securities and Exchange Board of India (SEBI) incorporated Clause 49 of the Listing Agreement.
“Independent Director means a non – executive director of the company who:
a) Apart from receiving directors remuneration does not have any material pecuniary relationships or transactions with the company, its promoters, directors, its senior management or its holding company, its subsidiaries and associates which may affect independence of the director.
b) Is not related to promoters or persons occupying management positions at the board level or at one level below the board.
c) Has not been an executive of the company in the immediately preceding three financial years.
d) Is not a partner or an executive or was not partner or an executive during the preceding three years, of any of the following:
i)The statutory audit firm or the internal audit firm that is associated with the company and
ii) The legal firms and consulting firms that have a material association with the company.
e) Is not a material supplier, service provider or customer or a lessor or lessee of the company, which may affect independence of the director and
f) Is not a substantial shareholder of the company.
g) Is not less than 21 years of age(7*).
“An Independent Director in relation to a company means a director other than a managing director or a whole time director or a nominee director :
a) Who in the opinion of the Board is a person of integrity and possess relevant expertise and experience.
b) i) Who is or was not a promoter of the company or its holding, subsidiary or associate company.
ii) Who is not related to promoters or directors in the company, its holding, subsidiary or associate company.
c) Who has or had no pecuniary relationship with the company, its holding, subsidiary or associate company or their promoters or directors during the two immediately preceding financial years or during the current financial year.
d) None of whose relatives has or had pecuniary relationship or transaction with the company, its holding, subsidiary or associate company or their promoters or directors amounting to two percent or more of its gross turnover or total income or fifty lakh rupees or such higher amounts as may be prescribed whichever is lower, during the two immediately preceding years or during the current financial year.
e) Who neither himself nor any of his relatives:
i) Holds or has held the position of a key managerial personnel or is or has been employee of the company or its holding , subsidiary or associate company in any of the three financial years immediately preceding the financial years in which he is proposed to be appointed.
ii) Is or has been an employee or proprietor or a partner in any of the three financial years immediately preceding the financial year in which he is proposed to be appointed of:
a) A firm of auditors or company secretaries in practice or cost auditors of the company or its holding, subsidiary or associate company.
b) Any legal or a consulting firm that has or had any transaction with the company, its holding, subsidiary or associate company amounting to ten percent or more of the gross turnover of such firm.
iii) Holds together with his relatives two percent or more of the total voting power of the company.
iv) Is a Chief Executive or Director by whatever name called, of any non-profit organization that receives twenty five percent or more of its receipts from the company any of its promoters, directors, or its holding, subsidiary or associate company or that holds two percent or more of the total voting power of the company (or)
v) Who possesses such other qualifications as may be prescribed(8*)”.
“The expression Independent Director refers to a non – executive director of a company who apart from receiving the directors remuneration, does not have any material pecuniary relationships or transactions with the company, its promoters, directors, senior management holding company or its subsidiaries and associates, which may impact his/ her independence(9*).
Independent Director means a person other than the employee of the company or an executive officer of the company or any other individual having a relationship which in the opinion of the issuers board of directors, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director. The following persons shall not be considered independent.
a) A director who is or at any time during the past three years was employed by the company.
b) A director who accepted or who has a family member who accepted any compensation from the company in excess of 1,00,000 US Dollars during any period of twelve months within three years preceding the determination of independence, other than the following :
i) Compensation for board or board committee service.
ii) Compensation paid to a family member who is an employee of the company.
iii) Benefits under a tax qualified retirement plan or non-discretionary compensation.
c) A director who is a family member of an individual who is or at any time during the past three years was employed by the company as an executive officer.
d) A director of the issuer company who is or has a family member who is employed as an executive officer of another entity where at any time during the past three years any of the issuer serve on the compensation committee of such other entity(10*)”.
What Constitutes Independence of Directors?
The nomenclature Independence means free from outside control, not subject to another’s authority. A man is said to be free if he is free from obligations. Similarly in the limelight of Corporate Governance Independent Directors are said to be free if they are free from the control of the management. Independence from Management is a vital factor for considering a director to be independent. This concept of Independence of Directors is recognized now globally as it is felt by the corporate experts and legislators after a spate of scandals, that it improves Corporate Governance.
Independence – An Ongoing Requirement
The Listing Agreement requires independent directors to disclose their share holdings in a listed company prior to the appointment to the company’s board. Under the new act, independent directors must give a declaration of independence at the first meeting of the Board in which they participate and thereafter at the first meeting of the Board in every financial year or whenever there is a change in circumstances which affects their status as an Independent Director. Several other restrictions have also been built into the new act to ensure that there is no financial nexus between an independent director and the company. The new act limits the remuneration of independent director to sitting fees, reimbursement of expenses for participation in the board and other meetings and such profit- related commission as may be approved by the shareholders.
The Listing Agreement mandates that the board of a listed company will have an optimum combination of executive and non-executive directors with not less than 50% of the board comprising of non-executive directors. Where the chairman of the board is a non-executive director, atleast one-third of the board should be independent directors. Where the Chairman is an executive director, atleast half of the board must be independent directors.
In contrast, the new act requires that atleast one-third of the total number of directors of every public listed company must be independent directors. In all other classes of public companies, the Central Government will have the power to prescribe the minimum number of independent directors.
The rationale of introducing the concept of independent director is lucidly explained by the J.J. Irani Committee Report wherein the committee observed that :
Given the responsibility of the Board to balance various interests, the presence of independent directors on the Board of a company would improve corporate governance. This is particularly important for public companies or companies with a significant public interest. While directors representing specific interests would be confined to the perspective dictated by such interests, independent directors would be able to bring an element of objectivity to Board process in the general interests of the company and thereby to the benefit of minority interests and shareholders. Independence, therefore is not to be viewed merely as independence from Promoter Interests but from the point of view of vulnerable stake holders who cannot otherwise get their voice heard. Law should therefore recognize the principle of independent directors and spell out their role, qualifications and liability. However requirement of presence of Independent Directors may vary depending on the size and type of the company. There cannot be a single prescription to suit all companies. Therefore number of Independent Directors may be prescribed through rules for different categories of companies.
This recommendation was accepted and the concept of Independent Directors was recognized and enacted in the new Companies Act.
Need For Independent Directors
The need for Independent Directors was felt by the Indian Legislators and the Corporate experts after the Satyam Debacle in the year 2009. Satyam case was perhaps the biggest corporate fraud case where M/S Satyam Computer Services Ltd caused loss to the investors to the tune of Rs. 14162 crores. The company head Ramalinga Raju and members of his family secured illegal gains to the tune of Rs. 2743 crores by various tricks. The fraud was perpetrated by inflating the revenue of the company through false sales invoices and showing corresponding gains by forging the bank statements with the connivance of the Statutory and Internal Auditors.
The annual financial statements of the company with inflated revenue were published for several years and this led to the higher price of the scrip in the market. In the process innocent investors were lured to invest in the company. Attempts were made to conceal the fraud by acquiring the companies of kith and kin. In order to avoid such scams in the future and to protect the interests of the investors, especially the minority share holders the concept of Independent Directors emerged.
The Companies Act, 2013 was enacted with a view to improve the standards of Corporate Governance and ensure transparency to the minority shareholders. The new act contains provisions pertaining to Independent Directors. Section 149(6) of the Act defines Independent Directors. Section 150 deals with the manner of selection of Independent Directors. Section 149 (12) talks about the liability of Independent Directors. Schedule IV of the said Act lays down a code for Independent Directors.
The presence of Independent Directors on the Board of a company would improve corporate governance, particularly for public companies or companies with a significant public interest. Corporate experts felt that independent directors would be able to bring an element of objectivity to the Board process in the general interest of the company and thereby to the benefit of minority interests and small shareholders. Finally it was felt by the corporate experts that the inclusion of independent director often brings a different point of view, a more knowledgeable view, and a more professional view.
Role of Independent Directors
Independent Directors have a key role in the entire mosaic of corporate governance. It is increasingly being recognized that independent directors occupy a pivotal position with respect to the progress of the company. In fact Independent Directors are considered as both a safeguard and a significant source of competitive advantage.
Neither the Listing Agreement nor the 1956 act prescribes the scope of duties of Independent Directors vis-a-vis the executive directors, the promoters, or the share holders, minority or otherwise. Independent Directors may be viewed as repositories of vigilance intended to ensure that the promoters and executive directors carry on the activities of the company in conformity with the interests of the shareholder as a whole. Alternatively, independent directors could be viewed as strategic advisors to the board, critical to maximizing revenue and overall value of the company.
The new act includes a guide to professional conduct for independent directors, which crystallizes the role of independent directors by prescribing facilitative roles, including offering independent judgement on issues of strategy, performance and key appointments, and taking an objective view on performance evaluation of the board. Independent directors are additionally required to satisfy themselves on the integrity of financial information to balance the conflicting interests of all stakeholders and in particular to protect the rights of the minority shareholders.
Qualifications of an Independent Director
A person in order to be appointed as an Independent Director must posses the following qualifications.
a) He should not be disqualified to be a director.
b) He should provide his DIN and a declaration that he is not disqualified to be a director.
c) He has to give his consent to act as a director which needs to be filed with the Registrar.
d) The Board has to declare that in their opinion he is eligible for appointment.
Disqualifications of an Independent Director
Clause 49 of the Listing Agreement prescribes a list of disqualifications for an Independent Director. A person is not an independent director if :
a) He has any material or pecuniary relationship other than directors remuneration including sitting fees and commission which may affect his independence.
b) He is not an independent director if he is related to the promoters or persons occupying management positions at the board level or at one level below the board.
c) He is not an independent director if he has been an executive of the company in the immediately preceding three financial years.
d) He is not an independent director if he is a partner or an executive or was a partner or an executive during the preceding three years with a statutory audit firm or internal audit firm associated with the listed company whether such relationship is material or not.
e) He is not an Independent Director if he is a partner or an executive of or was a partner or an executive at any time during the past three financial years in any legal or consulting firms that have a material association with the listed company.
f) He is not an independent director if he holds 2% or more of the voting share capital of the company or voting power of the company as per the list of share holdings or beneficial owners.
Manner of Appointment
Appointment process of Independent Directors shall be independent of the company management and while selecting independent directors shall ensure that there is appropriate balance of skills, experience and knowledge in the Board so as to enable the Board to discharge its functions and duties effectively.
The appointment of Independent Directors of the company shall be approved at the meeting of the share holders. In the Annual General Meeting (A.G.M) a notice must be served for approving the appointment of independent directors and such notice shall include a statement in the opinion of the Board, that the independent director proposed to be appointed fulfills the conditions specified in the Act.
The appointment of Independent Directors shall be formalized through a letter of appointment and the terms and conditions of appointment of Independent Directors shall be open for inspection at the registered office of the company by any member during normal business hours. Further the terms and conditions of appointment of Independent Directors shall also be posted on the company’s website.
Resignation or Removal of an Independent Director
The resignation or removal of an Independent Director shall be in accordance with Section 168 and 169 of the Act. An Independent Director who resigns or is removed from the Board of the company shall be replaced by a new independent director within a period of not more than 180 days from the date of such resignation or removal as the case may be. Where the company fulfills the requirement of independent directors in its Board even without filling the vacancy created by such resignation or removal as the case may be the requirement of replacement by a new independent director shall not apply.
The Satyam affair and other scandals abroad exposed the growing need to ascertain precisely the standards for determining the liability of independent directors for prevention and detection of fraud, in view of the limited roles performed by them in the company. These scandals taught the legislators and corporate experts in India and abroad a costly lesson which propelled them to take adequate urative measures.
As regards India, the legislators after such collapses enacted the new act which makes a considerable effort to bring the role of independent director in line with the changing needs of the economy. The primary objective behind the new acts’s provision on independent directors is to ensure transparency and independence and at the same time to bring value to the company by providing input on strategy, business, marketing, legal, compliance and other matters including performance of monitoring functions.
1. Ranjan. R – B.L.(Hons) Advocate
2. NASDAQ stands for National Association of Securities Dealers Automated Quotations.
It is an American stock exchange. It was bounded in the year 1971, by the National Association of Securities Dealers (NASD) NASSDAQ is owned and operated by the NASDAQ OMX Group. NASDAQ started trading on 8th February 1971 and it was the worlds first electronic stock market.
3. Cadbury Committee was set of in the year 1991 by the London stock exchange.
4. Greenbury Committee is committee established in the year 1995 under the chairmanship of Sir Richard Greenbury.
5. Higgs Committee passed its report in the year 2003 relating to the role of non executive directors.
6. Smith Committee was established in the year 2002 and it dealt with relationship between auditor and company.
7. Clause 49 of the listing agreement is a clause in the listing agreement. It was introduced by SEBI with a view to improve corporate governance.
8. Sec 149(6) of the Companies Act, 2013.
9. SEBI is a regulator authority established by way of an Act called the SEBI Act, in the year 1992.
10. Supra refer 2nd food note.