ISSUE VIII : Role of independent directors under clause 49 of the listing agreement and challenges of corporate governance

INTRODUCTION

The recent Satyam saga, where the promoter chairman of the company admitted to manipulation of accounts, inflating sales and profit and cash balances, has triggered an enormous debate in corporate India about the significance of corporate governance. The value involved in the Satyam debacle is in excess of $1 billion. Of course, India has no dearth of provisions on corporate governance in various enactments; however, the real issue emanates from the ability to follow these provisions in spirit and the means to monitor and enforce them effectively.

Corporate governance is a system established in corporations through which it is directed and controlled. Simply put, it refers to the policies that determine the allocation of duties and responsibilities amongst those responsible for running a company. The key hallmark must be transparency and accountability. The success of corporate governance, therefore, involves collaborative functioning amongst a variety of different agencies, be it the Board, independent directors, auditors, and regulators like the Securities and Exchange Board of India (“SEBI”).

The present bulletin deals with the special position, role and functions of independent directors on the Boards of Indian companies, and how they can be truly independent.

SEBI monitors capital markets and regulates corporate governance of listed companies in India through Clause 49 of the listing agreement which requires mandatory compliance. Clause 49 was first issued in 2000 but the latest version was issued by SEBI in 2004, and it came into force in 2005. A glaring, grim and a stark reality which has come to the forefront in a post-Satyam world is finding directors who can exercise their independence truly while influencing decisions of the board. The most challenging task lies in appointing individuals as independent directors who do not have relationships with the promoters.

1. What does the law provide: Essence of Clause 49

By including Clause 49 in the listing agreement, SEBI requires all listed companies to include a separate report on corporate governance in their annual report. The companies are under an obligation to submit quarterly compliance report to the monitoring cells set up by the stock exchanges within 15 days from the close of each quarter. This report has to be signed either by the compliance officer or the Chief Executive Officer (“CEO”) of the company. It has to necessarily consist of the following:

  • Composition of board
  • Non-executive Directors’ compensation and disclosures
  • Code of conduct
  • Provisions as to board and committees
  • Qualifications and powers of the audit committee
  • Role of the audit committee
  • Details of subsidiary companies
  • Board disclosures
  • Basis of related party transactions
  • Proceeds from public issues, rights issue, preferential issues etc
  • Remuneration of Directors
  • Management discussion analysis report & disclosures made to shareholders
  • CEO/CFO certification
  • Compliance certificate from the auditors or practicing company secretary

By virtue of Clause 49 of the listing agreement, SEBI made it compulsory for the board of all listed companies to have a combination of executive and non-executive directors1. Among non-executive directors, it should comprise of independent directors who will discuss, without bias, matters pertaining to company’s affairs. One of the principal objectives of having independent directors is to provide assurance to stakeholders that the board decisions will not be based on short-term developments and expectations.

The number of independent directors depends on whether the Chairman is executive or non- executive. If the Chairman of the Board is a non-executive director, one-third of the board must consist of independent directors, and if the Chairman is an executive director, half of the board must consist of independent directors2. If the Chairman is a promoter or is “related to any promoter” or to any other person occupying management positions at the board level or one level below the board, half of the board must consist of independent directors3.

In order to determine the constitution of the Board, SEBI has recently clarified that the phrase “related to any promoter” refers to:4

  • “If the promoter is a listed entity, its directors other than independent directors, its employees or its nominees will be deemed to be related to promoter entity;
  • If the promoter is an unlisted entity, its directors, its employees or its nominees will be deemed to be related to it.”

This implies that if the Chairman of company “A” is an executive director, an employee or a nominee of a listed company “B”, and company “B” is the promoter of company “A”, then half the members on the board of company “A” have to be independent directors5.

2. Meaning of Independent Directors

Clause 49 defines an independent director as a non-executive director of the company who:

  • does not have any material pecuniary relationships with the company, its promoters or any other member of the company, which may affect the non-executive director’s independence;
  • is not related to the promoters or persons on the board or one level below the board;
  • has not been an executive of the company in the immediately preceding three financial years;
  • does not hold more than 2% shares of the company;
  • was not associated as an executive during the preceding three years with the statutory or internal audit firm or any legal and consulting firm associated with the company;
  • is not a material supplier, service provider, lessor or lessee of the company, which may affect the independence of the non-executive director;6
  • should be over 21 years of age;7
  • is a nominee director appointed by an institution which has invested in or lent to the company.

Therefore, the law provides, at least theoretically, a mechanism via the presence of independent directors that is expected to improve corporate governance. The objective is that company appoints individuals of integrity, possessing relevant expertise and experience who will also satisfy the conditions for “independence.” Such independent directors are expected to ensure diligence during the board meetings. They can also record their dissent in the minutes whenever they disagree with board decisions. It is crucial that such independent directors rely on their expertise and assist the management by raising questions during meetings to steer the company in the correct direction so that the Board can make the best decisions.

3. Remuneration

Fees/compensation, if any, paid to non-executive directors, including independent directors has to be fixed by the board and requires prior approval of shareholders in the general meeting.8 However, if the payment of sitting-fees is made within the limits prescribed9 under the Companies Act, 1956 without approval of the Central Government, no prior approval of the shareholders in a general meeting is required.10

4. Resignation

If at any point of time, the independent director resigns or is removed from the board, he will be replaced by a new independent director within 180 days from the date of removal/resignation.11 However, this provision will not apply in case a company fulfils the minimum requirement of independent directors in its board i.e. one-third or one-half as the case may be, even without filling the vacancy created by such resignation/removal.

5. Independent Director and Audit Committee

Every listed company must have an independent audit committee consisting of a minimum of 3 directors as members. It is imperative that two-thirds of the members of such committee are independent directors.12 The chairman of the audit committee must be an independent director13 who is expected to be present at the time of the Annual General Meeting to answer shareholder queries.14

Just like the board, the audit committee is expected to meet four times in a year i.e. once every quarter. The quorum of such meeting will be either two members, or one-third of the members of the audit committee, whichever is higher.

However, it is pertinent to note that there should be a minimum of two independent members present during the meeting of the audit committee.15 Independent directors on audit committees provide one of the best ways of reinforcing both internal audit and annual statutory audit. In order to be effective, independent directors should have sound financial knowledge along with expertise in the area of business. After all, independence alone without competence can hardly make for a good independent director.

6. Liability

One of the most prevalent concerns faced by independent directors arises from the concept of vicarious liability. Presently the law does not make any distinction between directors who are in charge of the day-to-day affairs of the company and non-executive members attending only the board meetings. Since all the directors, executive and non-executive, are jointly responsible to the company, at times even non- executive directors may be imputed with liability for negligence with regard to the actions of their co- directors who are executive ones.

The Naresh Chandra Committee16 stated that “independent directors are not managers; they are fiduciaries who perform wider supervisory functions over management and executive directors.” It will be difficult to attract high level of quality independent directors on the boards of companies if they constantly have to worry about serious criminal liabilities under various acts.

However, independent directors fall under the scrutiny of law for acts committed by them. To impute liability, a direct nexus needs to be established between the offence and the role of the independent director. They cannot be held responsible for decisions taken by the executive directors for the day-to-day running of the business. No worthwhile talent can be expected to join a company’s board in the capacity of an independent director if certain limited immunities and safeguards are not provided to him.

7. The root problem

A significant problem is: how independent really are the independent directors? Despite the safeguards for listed companies as enumerated in Clause 49, the reality is that the role of independent directors is challenging and often quite complex. It is well known that Indian businesses are often family owned with a large degree of control exercised by the promoters even for listed companies such as Satyam where Mr. Raju held less than 10% of the equity. There is an inherent tendency to typically choose an individual who is closer to the interest of the family rather than the business.

It is equally pertinent to touch upon the choices available with independent directors to articulate dissent candidly in the event of disagreement with the decisions of the family-dominated Board. What happens in such a case? Theoretically, where the views of the independent director are not considered, he has the possibility to resign. But, such instances are rare, dissent and the real cause of resignation is never really known to the public but confined to the inner coterie of the family! In countries with stringent corporate governance the main objective behind a resignation is considered to be a fiduciary obligation of such independent director. India needs to go much further before corporate governance is really effective.

CONCLUSION

Independent directors have to examine the affairs of the company from the point of view of an impartial “third party”, who besides being an independent director on the board, has no other interest or stake in its affairs. However, frequently lawyers or chartered accountants act on the board as independent directors. The question arises about their independence if such lawyers or chartered accountants also provide professional services to the company. In such a situation, they already have an existing interest in the affairs of the company and may not be able to really be “independent” on the board. SEBI needs to define stringent polices to ensure that such loopholes are amended and only the most suitable candidate is allowed to hold the position of an independent director in a company.

The question is despite regulatory and statutory provisions, how far is India removed from implementation. Corporate governance as a way of business life is yet to take proper roots in this country. The regulations are being followed as a mere ritual. If listed companies want to expand, role of independent directors needs a re-look to protect the overall interests of investors or stakeholders. An independent director needs to be able to fearlessly express his dissent at meetings as well as involve himself in all commercial decisions which affect the overall interest of stakeholders. As a consequence, a proper legislation needs to be in place defining and governing the role, responsibility and duties of independent directors. Business in the future is not only going to be based on hard factors of business but also on soft factors like corporate governance standards and accountability. Corporate India needs to adopt a stiffer prescription on independent directors as a wise preparation for a challenging, but rewarding future in which the legislators need to learn lessons from the unfortunate Satyam catastrophe, and implement effective enforcement mechanisms!

1  See SEBI/CFD/DIL/CG/1/2004/12/10 dated October 29, 2004.

2 Ibid.

3  See SEBI/CFD/DIL/CG/1/2008/08/04 dated April 08, 2008.

4  See SEBI/CFD/DIL/CG/2/2008/23/10 dated October 23, 2008.

5 If company “B” is unlisted, then the Chairman can be an executive or an independent director, yet half the board of company “A” will consist of independent directors.

6  See  SEBI/CFD/DIL/CG/1/2008/08/04, dated April 08, 2008.

7 Ibid.

8 See Item 1, Para B of Clause 49.

91% of the net profits of the company if the company has a managing director or a whole time director or a manager. In any other case, the limit is 3% of net profits.

10 See proviso to Item 1, Para B of Clause 49.

11 See Item 1, Para C (iv) of Clause 49.

12 See Item II, Para A (i) of Clause 49.

13 See Item II, Para A (iii) of Clause 49. 14 See Item II, Para A (iv) of Clause 49. 15 See Item II, Para B of Clause 49.

16 Naresh Chandra, former cabinet secretary, constituted a committee to examine corporate audit, role of auditors and relationship between company and auditors.

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