: January 22, 2012 |
: Company Law
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The origin of independent directors should be discussed from the ownership of company visà-vis Management. The Board is a group of individuals appointed by the owners of the company to run the company in the interest of the stake holders. A company is a combination of various stake holders such as investors, employees, vendors, customers, governments and society at large. The management of the daily affairs of the company is given to the Board of Directors.
The representatives on the Board should run the affairs in a transparent manner to all its stakeholders. This is the triggering point for independent behaviour of the people on the Board for the common good. Globally, many times in the past, it has been observed that the members of the Board have taken decisions prejudicial to the interests of the stakeholders at large and ran the corporations for the material benefits of the few. This called for independent members on the Board in the process of adopting fair and transparent business practices.
Sarbanes-Oxley, (USA): An independent director is a member who, other than in his capacity as a board member may not (a) accept any consulting, advisory; or other' compensatory fee from the company; or (b) be an affiliated person of the company or any subsidiary thereof and other advisers, as it determines necessary to carry out its duties.
As per the definition of independent director in the code of Corporate Governance, an independent director should not have any pecuniary relations or transactions with the company or its promoters; his decisions should be independent of those who have controlling stake in a company and be in the overall interest of the company and its stakeholders. The Companies Act does not have a definition of `independent directors’ though the definition of independent director as given in the recently amended clause 49 of listing agreement is an inclusive definition, which says who could be independent directors. Clause 49 of the listing agreements defines independent directors as follows:
”For the purpose of this clause the expression ‘independent directors’ means directors who apart from receiving director’s remuneration, do not have any other material pecuniary relationship or transactions with the company, its promoters, its management or its subsidiaries, which in judgment of the board may affect independence of judgment of the directors.”
There are no provisions for appointment of independent director in the present Act. The appointment of independent directors in case of listed companies governed by the SEBI, but in case of unlisted company there is no such requirements.
The concept of “independent directors” is new to India; it was first brought to India by the 1999 Kumar Mangalam Birla committee on corporate governance. Three years later the Naresh Chandra committee gave governance more thought. Finally, in 2004 the Narayanmurthy committee affected changes to clause 49 of the listing agreement.
# Should not be related to promoters or the management at the board level or at one level below the board
# Should not have been a partner or an executive of the statutory audit firm or an internal audit firm or legal and consultancy firm, during the last three years
# Should not have been suppliers, service providers or customers of the company
# Should hold below two per cent of the shares of the company
# Should not have been an executive of the company in the immediately preceding three financial years
# Appointment of non executive director a beyond continuous period of nine years not permissible
# Nominee directors of banks or FIs will be considered as independent directors
Moreover, an Independent Director has been defined under various committee reports, a few examples being; the Cadbury Committee Report which recommended that majority of the Directors of the Company should be independent and “independent from management and free from any business or other relationship which could materially interfere with the exercise of their independent judgment. Secondly the Kumarmangalam Birla Committee Report states that “Independent Directors are directors who apart from receiving the Director’s remuneration do not have any other material pecuniary relationship or transactions with the company, its promoters, its management or its subsidiaries, which in the judgment of the board may affect their independence of judgment.”
As it stands today, the existing company law has no mention of independent directors. They can’t magically prohibit the scams from happening in a company; the very purpose behind appointing independent directors is to put checks and balances on each and every activity of the company and bring independence, impartiality and wide experience. It has been decided in Central Government Vs. Sterling Holiday Resorts (India) Ltd. and Ors. that “the Board of directors should be strengthened by appointing independent directors.”
Role Of Independent Director
Role in Corporate Governance: A corporation is the congregation of various stakeholders such as customers, employees, investors, shareholders etc. A corporation should be fair and transparent to its stakeholders in all transactions. This has become imperative in today’s globalized business world where corporations need to access global pools of capital, need to attract and retain the best human capital from various parts of the world, need to partner with vendors on mega collaborations and need to live in harmony with the community. Unless a corporation embraces and demonstrates ethical conduct, it will not be able to succeed.
Corporate governance is about the ethical conduct in business. In this regard, the managers make decisions based on a set of principles influenced by the values, context and culture of the organization. In India, the companies fill the Boards with the representatives of the promoters. These Directors may derive personal benefits rather than work for the benefit of the Company. This has posed great difficulties in the functioning of the company and is in contradiction of the principles of corporate governance. Independence of the Board is critical to ensuring that the Board fulfils its oversight role objectively and holds the management accountable to the shareholders. Therefore, ensuring some independent members on the Board can uphold corporate governance principles.
Protection of the Minority shareholder: The shareholders, especially the minority shareholders prefer coming to independent directors who provide transparency in respect of the disclosures in the working of the company as well as maintain a balance towards resolving conflict areas. In evaluating the board’s or management decisions in respect of employees, creditors and other suppliers of major service providers, independent directors have a significant role in protecting the stakeholders interests.
Risk Management and Review: It means identification, analysis and economic control of all such risks that may threaten assets, resources and earning capacity of the company. The risk may be financial, strategic or any other risks . The role of the Independent Director is to ensure that all the investment, funds, business transaction etc are heading in a right way and critically scrutinize the decision making process.
Role in relation to the board: As members of Board, their role is similar to any other director; Independent Directors primarily provide inputs to all key-decisions, such as strategies, performance evaluation and risk evaluation, affecting the company. Significant contribution is expected when matters relating to the committee on which they are members are being discussed. They should ensure that the Board addresses areas of concern on the running of the company and assist them in resolving the issues harmoniously.
While the legal duties and objectives are the same as Executive Directors, the time devoted by independent Non-Executive Directors to the company’s affairs is significantly less and therefore the degree of care, skill and diligence is lower than that expected from Executive Directors, and this can be seen as a disadvantage by some. However, certain standard of care has to still be ensured. As members of the Board, an Independent Director’s should, not only comply with the code of conduct but also establish, implement, monitor its adherence by other senior management and set an example for others.
Improving Internal Control : The consummate internal control is the imperative requirement of the company. It activates the overall management policies and keeps them under the feasible ranges. The process of the internal control commences right from the birth of new policies by the Board of directors and continues to the bottom the organizational structure. It includes development and operation of the management policies, administrative regulations, manuals, directives and decision, internal auditing etc. The responsibility of the independent directors is to act as supervisory body and monitor the internal control system. They must identify the imperfection in the internal control system and present them before the board to find suitable solutions to obviate them.
Statutory Compliances: To maintain high standards in the market and excellent reputation in the public or investors, stricter adherence to the statutory laws is a pre-requisite for the company. The postulates of good corporate governance require the Companies to enforce the multiple statutes and rules and regulations given there under. This facilitates the ultimate objective of protection of investors’ interest.
Clause 49 And Independent Directors
Clause 49 of the Listing Agreement, which deals with Corporate Governance norms that a listed entity should follow, was first introduced in the financial year 2000-01 based on recommendations of Kumar Mangalam Birla Committee. The report of the Committee was considered and adopted by SEBI Board in its meeting held on January 25, 2000. The recommendations are to be implemented through the amendment to the listing agreement of the stock exchanges. Internationally, listing agreement has been used in most markets to implement corporate governance in the listed companies.
Clause 49 of SEBI’s listing agreement mandated the appointment of independent directors in the board of directors. Clause I, sub clause (ii) of annexure-1 of clause 49 mandates that “where the chairman of the board is a non-executive director, at least 1/3rd of the board, should comprise of independent directors and in case the chairman of the board is an executive director at least ½ of the board should comprise of independent directors.
To ensure corporate governance the securities and Exchange Board of India (SEBI) has stipulated that effective from January 2006 at least one-third of the directors on the board of a company should comprise "independent directors". Known as 'revised clause 49', SEBI has made it clear that all listed entities would have to comply with this directive by December 31, 2005.
The revised clause 49 stipulates that in companies which have executive chairmen, at least 50 per cent of the board is required to have independent directors. For companies with non-executive chairmen one-third of the board must comprise independent directors.
Non-compliance with the provisions of corporate governance in clause 49 would invite penalties such as suspension of trading and delisting from the stock exchange. The onus of complying with this provision will not be restricted to companies listed on the stock exchanges; the JJ Irani Committee has recommended that the provisions apply to all "large" companies and has left it to the government to define the term "large." However, this provision also applies to even subsidiaries of publicly-listed companies and indications suggest that it may be extended to deemed public companies and, perhaps, even closely-held large private companies.
In fact, the government has indicated that it would, by December 31, 2005, bring down its representation on the board of the Oil and Natural Gas Corporation, to enable the oil major to conform what is now called the revised clause 49 of the 'listing agreement'. According to Y S Malik, joint secretary, company affairs ministry 3,000 to 4,000 people would be required to function as independent directors in about 6,000 listed companies, and various industry bodies have been asked to draw up a list of such persons. The government has estimated that corporate India will need 3,000-4,000 "independent directors" within the next few months to comply with SEBI's listing requirements. The issue of corporate governance and independent directors are closely inter-linked. The Irani committee has expressed the opinion that the presence of independent directors on the boards of companies in adequate numbers would help in improving corporate governance.
An effective Board of Directors is the most essential characteristic of all successful Companies. The Non-Executive Directors play a crucial role in implementing the principles of effective corporate governance. The business activities of the corporations are crossing the national boundaries and involve shareholders and investors from all around the globe. Therefore, there is an urgent need for appointment of independent officers at the top levels of company. The need for of Independent Directors has also arisen due to gradual changes in the mindset of the investors and shareholders. A common feature of such Companies is that they have systems in place, which allow sufficient freedom to the boards and management to take decisions towards the progress of their Companies and innovation, while remaining within a framework of effective accountability. In other words they have a system of good corporate governance. It is important that insiders do not take undue advantage of their position and take unfair advantage. In order to prevent such situation, the demand for Independent Directors has risen during the recent years in India. Independent Directors can counterbalance managerial infirmities in the company. They would ensure legal and ethical behavior of the company. They are the source of well conceived long term decisions for the company. They are deemed to provide the necessary personal and technical expertise in order to abate fraud, misappropriation by the company or its directors.
Independent Directors In India.
From the definition of Independent Directors, we achieve two main points in the context of our topic independent directors - Are they really independent or not. They are:- (1) Independence of Judgment and (2) No Material Pecuniary Relationship
Independent Directors- Independence Of Judgment
Independent directors, apart from receiving director’s remuneration, does not have any material pecuniary relationships or transactions with the company, its promoters, its directors, its senior management or its holding company, its subsidiaries and associates which may affect independence of the director.
Thus their decisions should be independent of those who have controlling stake in the Company and in the overall interest of the Company and its Stakeholders.
But in reality who appoints these Directors? No doubt that the shareholders appoint the independent director. But if we see the process of selection of the independent director, it is the existing directors who nominate the independent candidates for the post of the independent non-executive director, that too in consultation with the promoters and the shareholders accepts the nomination on the basis of the recommendation of the Board.
Moreover, as we know the majority shareholders(i.e. Promoters) can dictate the composition of the Board. Although all shareholders can vote on the appointment of Directors, the dominance of the majority ensures that their nominees prevail. This undermines the implied objective of clause 49. To be truly 'Independent', a Director cannot be, nor perceived to be, controlled. It is fallacious to expect an 'Independent Director' to exercise his or her mind impartially against the wishes or interest/s of the majority shareholders, when the tenure of his or her office depends on their appointment by the majority shareholders.
If the authorities are serious about practically ensuring a 'strong and independent element on the Board', then the clause 49 should stipulate that the appointment of Independent Directors should be made by an independent party and not by the majority shareholders.
Although it is well accepted that the duty of all directors is to protect the interests of shareholders including minority shareholders, it is the so-called 'Independent Directors' who are entrusted by the minority shareholders to protect their interests. In spite of their appointment by majority shareholders, 'Independent Directors' are expected to pay particular attention to the interests of the minority shareholders. But there are occasions where their interests may be compromised by the expectations of the majority shareholders.
As a guiding principle, independent directors should always act impartially, looking out for the best interest of the company, its shareholders and in particular its minority shareholders. 'Independent Directors' should discharge their duties without fear or favour.
If independent director does not fulfill their duty as a watch dog then it would amount to committing an offence. As Supreme Court in Municipality of Bhiwandi & Nizampur v. Kailas Sizing Works has observed that
“the authority is not acting honestly where an authority has a suspicion that there is something wrong and does not make further enquiries. Being aware of possible harm to others, and action in spite thereof, is acting with reckless disregard of consequences. It was worse than negligence, for negligent action is that, the consequences of which the law presumes to be present in the mind of the negligent person, whether actually it was there or not.”
So an independent director can not escape from his liability. They will be held liable equally if they will not take any action against the wrong committed in his knowledge.
The above clearly suggests us that its possible for persons well known to the directors to get elected to the Board. If that happens(it normally does happen) then it’s the very first juncture at which independence is lost. Of course, when independent candidates are persons well known in the business or academics circles, additional justification is hardly needed for their appointment.
Thus the bottom line is that the Independence of judgment characteristic of Independent Directors is far from reality.
No Material Pecuniary Relationship- Apart From Receiving Directors Remuneration
Another interesting angle is the compensating factor. An independent director is compensated for his services by way of sitting fees and commissions. The provisions relating to sitting fees and commission to independent directors are as follows:
1. Sitting Fees [Sec.310] for each meeting of Board or Committee thereof
* In case of Companies with Paid up Capital and Free Reserves of Rs. 10 Crores and above or Turnover of Rs. 50 Crores and above - Not to exceed Rs. 20,000 per meeting
* In case of other Companies - Not to exceed Rs. 10,000 per meeting.
2. Commission to Non Executive Directors (i.e. including independent directors) [Sec. 309]
* Not to exceed 1% of Net Profits if the Company has a MD or WTD or a Manager
* Not to exceed 3% of Net Profits, in any other case
We can see from the above provisions that the sitting fee cannot exceed Rs. 20,000 or Rs. 10,000 as the case may be, for each meeting of the board or committee thereof. No man of repute would lend his time and energy and act as an independent director for sheer sitting fees and take independent decisions for the sake of interest of a Company and its stakeholders.
The very reason of taking up the post of an Independent Director by a man of repute is the Commission which he receives under section 309 of the Companies Act, 1956 as stated above. Where the commission is linked to the Company’s performance, the very objective of prohibiting such directors from accepting a salary is defeated and to some extent thrown in garbage.
Also, the Articles of Association of most of the Companies mandates that directors have to hold a minimum number of shares in the Company so as to qualify for the directorship and many individuals holding shares of the Company (though less than 2%) also sometimes get appointed as independent director. Once compensation is linked to Company’s profit or share price performance, doesn’t this create a vested interest in ensuring that the Company’s reported numbers are good?? Obviously, the situation of reporting of inflated numbers cannot be denied.
Hence, how can you take for granted that an individual appointed as an independent director would act in favour of the interest of the Company and stakeholders. He would rather focus on increasing the net profits by taking such decisions ( whether ethical or not) which could lead increase in his percentage of commission by shaking hands with the promoters neglecting thereby the responsibility towards the Company and the stakeholders
Thus, it can be seen that an independent director is dependent on the Company’s profit as his commission is calculated on the basis of the net profit and on share price performance if he holds good number of shares of the Company (though less than 2%).
An independent director is expected to act as watch dog of the board and protect the interest of shareholders. Since they are handpicked by the promoters himself so they prefer to be a friend of the promoters rather then be the watch dog of the board. Though independent director is paid by the company, it must be borne in mind that the company is not only owned by its promoters but all share holders so they are supposed to represent the interest of the minority shareholders. There are circumstances where independent directors are not independent, which broadly includes:-
a) Selection procedure
A lot of emphasis is placed on the “independence” of independent directors their selection is still in the hands of owners of the company. No process of selection has been prescribed for the independent directors, as they are directly handpicked by the promoters. Promoters in control may take decisions that are not in the interest of small shareholders, an independent director must keep in mind the interest of all stakeholders. Such procedure for their selection raises question on their independence at the board. They can not be as independent as they are expected to be, if they are going to be appointed by the owners. This procedure has to be changed for the independence of directors. As long as they are appointed by management, the concept of independent directors is a myth, for truly independent directors, they have to be nominated by the SEBI which is a regulatory authority. If they have a right to regulate, then surely they have a right to even suggest the appointment of directors.
b) No age limit
There is no age limit has been prescribed under Companies Act, 1956 and by the SEBI. According to Indian companies Act a minor can become a director since no age limit is prescribed. This point must be rethink as a person who is under 18, as surly cannot acquire enough experience to become an independent director of a company. It’s not the quantity of Independent Directors but the quality of Independent directors that make difference. There must be an age limit which can justify the position of an independent director.
c) No specific qualification is required
There is need to focus on the quality of independent directors who are going to be appointed. They should be qualified enough so that they can ask right questions at the right time when they are at board. The most important requirement is his ability to stand up for minority shareholders, who are not represented on company boards. They need to be sound in judgement with an inquiring mind. Clause 49 of the Listing Agreement of the stock exchanges and the Companies Bill, 2008 introduced in Lok Sabha’s last session does not prescribe the minimum qualification or experience essential. Presence of independent director on the board makes sense only if they are well-educated, can add value to the company, and represent minority shareholders’ interests. The government and SEBI must review the qualification for independent directors.
d) No right to interfere in the day-to-day operations
An Independent director has no right to interfere in the day-to-day operations of company. They have right to intervene in any misgivings or misdeeds. They are supposed to support the management in getting the delivery of what the objectives of the company are to its shareholders. If a director can not get into a company’s day-to-day operations, he can not understand how it is governed and will not be in the position to fulfill his responsibilities. There is no separate law under which an independent director operates; he has no legal protection from the management so that he can raise his voice fearlessly. For the involvement of independent director in day-to-days operations of company they must be given authority so that they can intervene in the day-to-day operations of company and may be able to raise their voice.
e) No time limit for replacement of an independent director
There is no guideline prescribing a time limit for replacement of an independent director in case there is a resignation or removal or death of an existing one and promoters are taking a plea that they have not been able to find a replacement, which could stretch for indefinite period. The fees or remuneration of an independent director has grown so substantially in the last three years that an individual is often tempted to have an extended stay in the organization. Most of these directors would go by the decision of the promoters of the company without examining the details of company. To retain the independence of director there is need to rotate such directors periodically or by any other method whereby the independence of independent director is secured.
On the basis of the above, we can conclude by saying that the Independent directors are not independent as such. They are dependent on the major shareholders (i.e. Promoters) for their appointment, on management for the information given on the position of the Company and on the statutory auditor and internal auditor for the information on financials of the Company. Hence there is no independent method of verification of facts.
On broader basis, it is generally true that independent directors are hired neither for better corporate governance nor for protecting minority shareholders interests. They are actually hired for compliance of listing agreement.
Satyam episode is proven to be tragic for the Indian corporate world, but it should be considered as a wake-up call to many. The Satyam case brought out the failure of the present corporate governance structure, in which independent directors failed to perform their responsibility effectively. As in Satyam case independent directors lacked commitment; they failed to live up to the stakeholders’ expectations. The only way independent directors can stop wrong doing by acting collectively.
Independent directors are still the only hope to instill discipline in the murky world of corporate finance, provided their independence is not being compromised. If they are no more independent then their appointment in a company will be meaningless. This position deserves to be corrected by empowering SEBI and the Indian government.
We can clearly see from the above discussion that Independent directors are not independent. Hence the very word independent is a misnomer. They should be rightly named as dependent directors.
Therefore, we can conclude that independent directors are though appointed in the interest of the Company and the Stakeholders, they end up doing good to the Promoters
Even if one or two of them are independent of there judgment and takes a fair and prudent view, then also at the end of the day the decision of the majority prevails, diluting the effectiveness of their view.
There is no need to implement new laws; all we need to do is to renew existing laws. Independent directors may not be in a position to stop management fraud perpetrated at the highest level, but with high level of commitment and due diligence they should be able to identify signals that indicate that everything is not going right.
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