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Can Independent Non-Executive Directors Become the Directing Mind And Will of the Corporation?

Written by: Pawan Agarwalla, CA - Mumbai
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The following passage of Viscount Haldane, Lord Chancellor, in Lennard's Carrying Company Ltd v. Asiatic Petroleum Co.Ltd (1915) AC 705) highlights how the non-executive directors' contribution can be instrumental in complementing the executive's competence:
"My Lords, a corporation is an abstraction. It has no mind of its own any more than it had a body of its own; its active and directing will must consequently be sought in the person of somebody who for some purposes may be called an agent, but who is really the directing mind and will of the corporation, the very ego and centre of the personality of the corporation. That person may be under the direction of the shareholders in general meeting; that person may be the board of directors itself, or it may be, and in some companies it is so, that that person has an authority to co-ordinate with the board of directors given to him under the articles of association, and is appointed by the general meeting of the company, and can only be removed by the general meeting of the company."

The board of a company comprises of executive and non-executive directors. Though the law treats them simply as directors and both carry equal responsibility, they have different roles to play. The non-executive independent directors are generally given the chairmanship of important committees like Audit committee, Nomination committee and remuneration committee. They are closer to action. They can question the executives directly. They observe from a distance how well executives are performing their duties. An attempt has been made in this article to critically analyze the role and effectiveness of independent non-executive directors especially in the light of Higgs Committee Report in U.K.

Duties And Responsibilities of Directors

A director should first understand his relationship with the company and the shareholders as this relationship is what shapes his roll and responsibilities vis a vis the company and the shareholders. Unfortunately, there is no statutory provision to define this relationship. It is the judiciary which has over a period of time defined the relationship. As early as in 1866, that is about a century and half back, in Ferguson Vs. Wilson, the Chancery Division held that a company though a legal entity, cannot act by itself. It can act only through its directors and as such the relation of a director with the company is that of principal and agent and therefore general principles of law of agency would govern the relationship between the company and the directors. The relationship was further defined in Forest of Dean Coal Mining company case by Chancery Division in 1878 that directors, having been entrusted with the affairs of the company, are trustees of the company and therefore they are in a fiduciary relationship with the company. These judicial pronouncements have been universally accepted and applied all over and now the position of directors' vis--vis the company is that they are not only agents but also trustees. This relationship would mean that the directors should always act in the interest of the principal that is the company and in discharge of their fiduciary responsibilities, they cannot benefit at the cost of the company.
As far as the relationship with the shareholders is concerned, the legal position which has evolved over a period of time, is that the directors are neither agents nor trustees of the shareholders but special circumstances depending on facts of a particular circumstance may give rise to that relationship.

In Principles of Modern Company Law, 6th Edition, 1997, Gower has summarized the legal position as (quote) "In applying the general equitable principles to company directors, four separate rules have emerged. They are (1) that directors must act in good faith in what they believe to be the in the best interest of the company (2) they must not exercise powers conferred upon them for purposes different from those for which they are conferred. (3) that they must not fetter their discretion as to how they shall act and finally that without the informed consent of the company, they must not place themselves in a position in which their personal interests or duty to other persons are liable to conflict with the duties to the company".

Thus over a period of time the view that a director's duties to a company is that of a man of ordinary prudence has changed and now it is more than that of a man of ordinary prudence.

The role and responsibility of an individual director, of course, would depend upon the nature of his directorship. Broadly, there are three types of directors. Full time, executive director who is normally a paid employee of a company having some functional responsibility, non executive but non independent director who is normally a promoter of the company or having high stakes in the company and finally independent directors who are not full time directors. There is another class of directors known as nominee directors representing some interests like lending institutions etc. An executive director, by very nature has much more responsibilities than non executive directors. In law it is their responsibility to ensure compliance with provisions of law failing with they could be held liable as officers in default. As far as independent directors are concerned, the position of law is nebulous.

Of late thee has been great emphasis in appointing independent directors on the Boards of companies. On the basis of Naresh Chandra Committee Report, in the new Companies Bill introduced in the Parliament, certain provisions have been made in relation to independent directors. These provisions do not define an independent director but only specify grounds which would disqualify a person from being considered as an independent director. The rationale of having independent directors on the Board of a company is with an idea to keep a special eye on the finances of a company particularly through the audit committee. It is a known fact that most of the companies which went into difficulties in USA did have independent directors. Mere presence of directors who are independent in terms of the provisions of law does not mean that there would be checks and balance. What is to be ensured is that these directors think and act independently. Even though in law, the directors are to be elected by the shareholders, yet, in practice, the directors proposed for election are normally the nominees of the promoters.

The selection and appointment of independent directors should be transparent and on certain valued basis. Therefore, the companies should have an entirely independent nomination committee which should determine the qualifications for Board membership and should identify and evaluate candidates for nomination to the Board. It would be more appropriate that the code of Corporate Governance of a company should specifically include the qualifications and attributes that the company seeks of an independent director. A critical element of a director being independent is his independence to the management both in fact and perception by the public. In considering the independence, it is necessary to focus not only on whether a director's background and current activities qualify him as independent but also whether he can act independently of the management. In other words, the independent directors must not only be independent according to the legislative and stock exchange listing standards but also independent in thought and action i.e. qualitatively independent. Such qualitative independence will ensure that directors think and act independently without regard to management's influence.

Qualitative directors' independence should include the will and ability in terms of knowledge and experience to ask the hard questions required to provide effective oversight and character and integrity in general and especially in dealing with potential conflict of interest situations. The Board to be successful should have mix of skills and should be tailored to meet the needs of the company. Even though, there could be no precise mix of qualifications and experience, which will depend on various factors, yet, specialists in the areas of accounting and finance, technology relevant to the company, corporate management, marketing and industry knowledge etc could be considered for independent directors. Perhaps, a skill matrix which lists desirable competency versus those presently present on the Board is useful in determining where the holes exist on the Board, which skills compliment each other etc. Board dynamics are difficult to prescribe as groups of people gather together to make informed decisions about the direction of the company. Although, the level of knowledge, integrity and independence necessary to carry out the functions of a director are difficult to summarize, the behavior characteristics of a good director should include the attributes of asking the hard questions, working well with others, having industry awareness, providing valuable inputs, availability when needed, be alert and inquisitive, making long range planning contribution etc.

The independent directors could effectively and substantively contribute if they are empowered to meet at regularly convened executive sessions without participation of management or employee directors so that they could openly and freely discuss the affairs of the company. There has always been a conflict of opinion as to whether the combination of the position of Chairman and CEO is preferable or two different persons should hold these positions independent of each other. Each has its own merits and demerits and it is for the Board to decide the best alternative that is suited to the company.

Accountability is an important element of Board effectiveness. There should be some mechanism for evaluating the performance of the directors. Perhaps, a system of 3 tier director evaluation mechanism could be evolved by which the performance of the Board as a whole, the performance of each committee and performance of each individual director is assessed. Since the shareholders who elect the directors lack the knowledge of the inner working of the Board, the Board could disclose their mechanism and process of the 3 tier evaluation to the shareholders. How and in what manner the evaluation is to be carried out has to be specifically spelled out by the Board.

Now comes the liability of the directors. There are two types of directors liability. One relating to statutoty compliance and the other is in relation to their fiduciary obligations. The Companies Act and other Acts lay down various requirements on the part of the company and most these provisions provide for penal action against the directors. As I have said earlier, the extent of liability of a director would depend on the nature of his directorship. No doubt, full time directors being offices in default have to be fully liable while part time directors may not be so liable. But as far as fiduciary duties/obligations are concerned, any breach by any director would visit them with liability. Our Supreme Court has considered this issue of fiduciary liability. It has observed in Official Liquidator Vs. PA Tandulkar (AIR 1973 SC 1104)[As mentioned by shri S.Balasubramanian in one of his speeches.]

The Higgs Report

The report by Derek Higgs into the role and effectiveness of non-executive directors was published on 20 January 2003. The report lays considerable stress on more demanding and influential role of non-executive directors (NEDs). The report is so comprehensive that it can definitely serve as guide to the corporate in our country.

Composition of Board

currently, the Combined Code of good Governance and code of best practices(in short, The Code) requires that the board should include a balance of executive and non-executive directors (including independent NEDs) - aiming to ensure that no individual or group can dominate the board's decision making. Taking the board as a whole, the NEDs (whether independent or otherwise) must comprise not less than one-third of the board, and a majority of the NEDs should be 'independent' However, the Higgs report requires that at least half of the board, excluding the Chairman, should be independent (NEDs).This recommendation will herald a shift in the overall power of the board in favor of independent NEDs, and away from executive management.

The chairman
The Code already recognizes that the roles of chairman and chief executive involve two distinct tasks - running the board (chairman) and taking executive responsibility for running the company's business (CEO). The Code currently accepts that these tasks may be combined in one person, although such a step does require public justification. The report also requires that a chief executive should not go on to become chairman of the same company; and on appointment, the chairman should be seen to be independent (although it recognizes that, following appointment, the chairman will cease to be independent due to his greater involvement with the executive team). The recommendation that a chief executive should not go on to become chairman of the same company will be unwelcome to many companies, and has attracted more criticism than other aspects of the Report.

Role Of Non-Executive Directors

The non-executive directors should:
1. contribute to and constructively challenge development of company strategy.
2. Scrutinize management performance.
3. Satisfy them that financial information is accurate and ensure that robust risk management is in place.
4. Meet at least once a year without the chairman or executive directors - and there should be a statement in the annual report saying whether such meetings have taken place.
5. Be prepared to attend AGMs and discuss issues relating to their roles (especially chairmen of committees).
6. Have a greater exposure to major shareholders (particularly the senior independent director).

Senior independent non-executive director

currently, the Code recommends that there should be a recognized senior independent NED (irrespective of whether the roles of chairman and CEO are combined) who must be identified in the annual report.

The Report envisages an expanded role. Currently the Code tasks the senior independent director as the person, other than the chairman, 'to whom concerns can be conveyed'. The Report proposes that the senior independent director should be available to shareholders if they have concerns that have not been resolved through the normal channels, or for which contact through the normal channels is inappropriate. In addition, the senior independent director should develop a balanced understanding of the concerns of shareholders by attending sufficient of the regular meetings between management and the major shareholders.

The Report contains guidance on the recruitment and appointment of NEDs, and envisages a more developed role for nomination committees (which should consist of a majority of independent NEDs and be chaired by an independent NED.

The meaning of independence

when the board determines that the director is independent in character and judgment and there are no relationships or circumstances which could affect or appear to affect the director's judgment'. Such relationships or circumstances would include cases where the NED:

* is a former employee of the company or group - the NED will only be treated as independent five years after the employment has ended;
* has a material business relationship with the company either directly, or as a partner, shareholder, director or senior employee of a body that has such a material relationship - the NED will also cease to be independent if he has had such a relationship within the last three years;
* receives or has received additional remuneration from the company beyond the director's fee;
* participates in the company's share option scheme or a performance-related pay scheme;
* is a member of the company's pension scheme;
* has close family ties with any of the company's directors, senior employees or advisors;
* holds cross-directorships or has significant links with other directors via involvement in other companies or bodies;
* has served on the board for more than 10 years; or* represents a significant shareholder.

Tenure and commitment
stricter recommendations are introduced relating to the re-election of NEDs. Under the Code as it currently stands, NEDs are required to be appointed for a specific term and then be subject to re-election thereafter at intervals of no more than three years. There is currently no maximum term (although various shareholder bodies already envisage that a NED's 'independence' will be lost after 10 years' service).

The Report limits the term that can be served by a NED. It recommends that a NED should normally be expected to serve two three-year terms unless exceptional circumstances make a longer term appropriate. Any extension beyond six years must be justified. Further, any NED serving nine years or more must be re-elected annually. Once a NED is appointed, the NED must inform the chairman before any new appointments are accepted; the board must also be informed.

The Report endorses the current recommendations of the Code that levels of board remuneration should be sufficient to attract and retain directors but should not be more than is necessary. The Report provides more detailed recommendations in relation to the remuneration of NEDs by stating that NED fees should be built up from an annual fee, meeting attendance fees and additional fees for chairmanship of committees and NEDs should have the opportunity to take part of their remuneration in shares but they should not be granted options.

The Indian Scenario
The term "independent Directors" became a part of the Indian corporate lexicon after the publication of the Kumar Mangalam Birla committee report which resulted into introduction of clause 49 in listing agreements. The committee mentioned that 'independent directors' are those directors who apart from receiving directors remuneration do not have any material pecuniary relationship or transaction with the company, its management or its its subsidiaries which in the judgment of the Board may affect their independence of judgment. Clause 49 also prescribes that Audit Committee should comprise of majority of independent directors.

With the integration of the Indian economy into the world economy, -there is consensus among the corporate leaders that the corporate governance in India should conform to international norms. Once Mr. Rosie Catherwood , director of Dewe Rogerson had said that " while Indian companies were rated high on ability, they continued to suffer from low credibility amongst shareholders. He further mentioned that only multinational and public sector units operating in India have been rated highly on management credibility. While MNCs score for the quality of management that they offer, PSUs are rated highly for the transparency of management."

Barring a few exceptions, in India the appointment of independent or non-executive directors has become a matter of mere legal compliance. Most of the companies still function in the same old fashion and the non -executive directors has hardly any say in the management of a company. In most of the companies, hardly any relevant information is passed on to the directors and the meetings of the Board discuss minor and routine matters. The Board meetings are normally held once in three months and that too for 2 to 3 hours only. It is obvious that promoters would prefer to appoint their cronies and faithful persons on their board to have minimum interference of the outside directors.

But a million dollar question begging an answer is that when the Indian businessman will come out of the pond and start swimming in the main stream of global village. How will they satisfy the foreign institutional investors who are demanding greater professionalism in the management of Indian corporate. Even the lending institutions are now giving much more emphasis to good and efficient corporate governance.

It is true that the law alone cannot bring changes and transformation. A judicious mix of regulations and voluntary compliance will play an important role in developing a system of good corporate governance.

Can the Independent Directors really Direct the Company?

The Cadbury Report has observed that 'every public company should be headed by an effective board which can lead and control the business.' The following propositions will highlight the importance of independent and non-executive directors on the board of a company:
1. The non -executive directors, when carefully chosen, can complement the Board's overall strength with their knowledge of best practice outside the company.
2. Their role should not be to do the job of the executive but to act as candid counselors to the guide the company in benchmarking standards and its level of ambition.
3. This is a function not of numbers but caliber.
4. The non-executive directors must concentrate on a few companies rather being involved with up to fifteen companies which the companies act permits.
5. Non-executive directors can bring a broader view to the company. They bring external and wider perspective and independence to the decision making.
6. To render effective services the NEDs should be allowed to seek independent professional advise at the cost of the company.
7. The resume of the NEDs should be made available to the shareholders along with the proposal of their appointment or re-appointment.
8. Non-executive director5s should be given immunity from the responsibility for compliance with procedural matters.
9. The remuneration of the non-executive directors should be commensurate with the time they devote and experience they possess.
10. Non-executive directors who are not qualified professionals (e.g. Chartered Accountants, Companies Secretaries etc.), should undergo proper training before they assume directorships.

Qualities of a director

It is not uncommon that on the Board of directors of a commercial enterprise a retired bureaucrat , a celebrity like a film artist, a retired major general from the army, a retired judge from the High Court or the Supreme Court etc are nominated. There is nothing wrong in this approach per se but one must remember that more often than not these directors prove a decoration on the Christmas tree. In his though provoking book "The Brave New Manager" the author on page 142 has given an interesting example; When one such Major-general, CEO of public sector company, enquired from the other Majors-turned-managers, as to how they found the assignment of building the dam for a hydroelectric project, the answer came- "Those who had spent their entire military career in demolishing dams are now being asked to build one. We were taught to demolish and not to build."

Business has become complex, competitive, risky and challenging. Globalization has made the outcome of a commercial activity unpredictable and uncertain. Today it is not Ford competing with Toyota, its Ford competing with Ford of Europe as has been observed by Tom Peters. At a conference held in Cochin, Abid Hussein, while talking about globalization, said:
"There was a time when the Americans used to say, what is good for the General Motors is good for America and what is good for America is good for general Motors. No longer so. During the Bush period, the Americans gave the slogan, "Be American, Buy American." I have seen those posters. I have seen those handbills. The movement did not last more than 10 days. Men and women came out of their houses and tore those posters and handbills into bits and pieces. The point was that, if the American companies are not able to give me what I want, you can't stop me from buying the goods produced by other countries."
The cardinal sin of management is wrong selection, or a chain or wrong selections. I call it 'cardinal' because it is the most horrendous 'sin' of management. No sin equals it. Factors like caste, creed, color, province, language and blood-relationships are the major factors responsible for the commission of this cardinal blunder. One may imagine that family-controlled (Pedi-type) companies alone suffer from that malady. This is totally incorrect to imaging so. We know, abundantly, about politically-defeated MLA's and MPs being rehabilitated as Chairmen of state and central government undertakings. We all know the results of such appointments: persistent losses, extremely low morale, and flight of high caliber / honest men and women.

Corporate structures fail because they have given the least importance to their man-power, or they have prospered because they have given a paramount consideration to their man-power, somewhat like this: "Raze down my factories, take away my plant and machinery, but give me back my men, and I will build a new." (B.T. Dastur, in his article. 'Why Corporate Fail?')

The composition of the Board should be such as to provide vast array of expertise and business knowledge and correct direction to the company. A non-executive director should be able to devote enough time in the affairs of the company. The importance of non-executive director has been underscored by SEC Chairman Arthur Leavitt, in warning against multiple directorships: "I don't care how talented you are, you can't be a good watchdog if you're only on patrol three times a year."

The appointment of independent non-executive directors of the Board of a Corporation is not a panacea for all the evils. Nor is the system of corporate governance an innovation like 'Eureka'. However, as Mr. Amit K. Vyas says in one of his article," it would definitely act as a spirited move towards achievement of excellence by the corporate not only in the terms of increased profits and revenue but also in terms of respectability for the laws of the land, protection of interest of shareholders, creditors and employees of the company." Let us not forget that these directors are a part and parcel of our society. We cannot have a better Board of directors than the society itself. A company alone cannot fight the fierce battle of corruption and other social abuses. But collectively, any problem can be tackled and a solution found. The need of the hour is to combat these evils privately as well as publicly. Nothing happens in this world, unless we intend it to happen. Let the stories of good corporate governance be given wide publicity. WE need more and more Azim Premji and Narayana Murthy. The writing on the wall is very clear. Unless ethics are as important to us as economics, fair play as crucial as financial success, morals as vital as market share, we run the risk of being blotted out of our stake holder's landscape.

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