Introduction
Although a company is considered a separate legal entity, it relies on its agents to carry out its business and necessary functions. Typically, the directors act as the agents and are compensated through salary or a share of the profits. However, it is important to note that the relationship between a director and the company is complex, and modern corporate structures require agents with different specialties and capacities.[1] There are two main categories of directors: Executive Directors and Non-executive Directors. Executive directors are highly involved in the day-to-day operations of the corporation, whereas non-executive directors are selected to carry out specific responsibilities, rather than handling daily affairs. However, both types of directors are considered employees of the company and are responsible to all stakeholders, including shareholders and creditors.[2] These directors have both fiduciary duties and contractual duties, and failure to fulfil these duties can result in civil and criminal penalties. Over time, it became apparent that there was a need for a distinct group of agents who could act in the best interests of the company without being influenced by their own personal interests or agendas, in order to promote principles and transparency.[3]
Therefore, a new category of non-executive director was suggested, which was later called as “independent directors”. This proposal was first put forward by a committee called “the Cadbury Committee”, which emphasized that independent directors should make decisions independently.[4] Independent directors are not employed by the company and their role is not to be involved in the company’s operations, but rather to ensure that the company operates in a transparent, accountable, and ethical manner through oversight.[5]
The concept of independent directors brought about a significant shift in corporate governance, particularly following high-profile scandals such as the Enron case in the US and the Satyam controversy in India.[6] As a result, the Companies Act of 2013 incorporated provisions related to independent directors, which explicitly state that they should have no financial ties to the company to ensure their impartiality.[7]
This project will examine various aspects of the legal responsibilities of independent directors in India, including their duties and liabilities, and compares them to those in other countries. The project will also explore the protections afforded to independent directors and the associated liabilities. Finally, the author proposes changes to the current model of independent director liabilities.
Page Contents
Who can be Independent Director
Section 149(6) of The Companies Act, 2013 defines an Independent Director as any director who is not a managing director, whole-time director, or a nominee director.[8]
Certain conditions for the same are:
- According to Section 149(6)(a) of the Act, the Board must believe that the individual being appointed has integrity and possesses relevant expertise and experience.[9]
- Section 149(6)(b) and (c) specify that the individual being appointed as an independent director must not be a company promoter or related to the promoters or directors of the company. Additionally, Section 149(6)(d) and (e) state that the individual must have no financial ties with the company, nor should any of their relatives have had any financial connection with the company.[10]
- Clause (e) of Section 149 states that individuals being appointed as independent directors must not hold certain positions within the company, nor should their relatives. These positions include key managerial personnel, employee, proprietor, partner, or Chief Executive/Director of a non-profit organization. Additionally, individuals and their relatives must not hold two percent or more of the total voting power of the company in any of the three preceding financial years.[11]
Need to have Independent Director
Having independent directors on the board of a company can bring several advantages. Firstly, it can help to control internal processes and prevent mismanagement or fraud, which can be reported to shareholders and the public.[12] Additionally, independent directors can offset management flaws, ensure legal and ethical behaviour, strengthen accounting controls, and increase the company’s popularity through their contacts and expertise. They can also contribute to long-term decision-making and assist with succession planning through membership in the nomination committee, ultimately helping the company to survive, grow, and prosper over time.[13]
Independent directors are also crucial in ensuring that they are not influenced by management and act as trustees for shareholders. This means that they must be fully aware of the company’s operations and take appropriate action when necessary. The duties and responsibilities of independent directors are outlined in Schedule IV of the Companies Act, 2013.[14] The code emphasizes significant functions such as protecting the interests of all stakeholders, including minority holders, balancing conflicting interests, evaluating management performance, mediating between management and shareholder conflicts, and more. Independent directors are also expected to attend company general meetings and stay informed about company matters.
Independent Directors – Duties and Liabilities: An Overview of Indian Model
It has been noticed that in India’s corporate sector, those who hold power and manage the businesses are typically closely related to one family.[15] This circumstance highlights a crucial need for independent directors to be involved in managing companies, especially in the wake of scams like the Satyam and PNB scams, among others.[16] In such a situations, Independent directors, who have no personal stake in the company’s affairs, can play a vital role in ensuring its proper management.
The Companies Act, Securities Exchange Board of India (SEBI), and (LODR) Regulations, 2015, along with judicial decisions, are the primary sources of guidance on the responsibilities and obligations of independent directors in India.[17] The Companies Act outlines the necessary qualifications and duties of independent directors in Section 149 (4) (6) & (8)[18] and Schedule IV. The schedule lays out the specific duties that independent directors must follow to promote the interests of all stakeholders.[19]
The following section discusses the liabilities of independent directors:
A. Fiduciary Duty – A Common Law Approach
According to English law, directors of a company are required to act with good intention and give priority to the interests of a company over their own benefits. This duty apply to all directors, including executive, non-executive, and independent directors.[20] The reason for imposing this duty on directors is that they are responsible for managing various activities of the company, and they have a primary responsibility to uphold the interests of all stakeholders.[21] The principle of fiduciary duty has been followed under common law since the beginning of the company business form. In India, Section 166 of the Companies Act also lays down the foundation for a fiduciary duty, which is similar to that of common law. A breach of this duty is likely to result in civil consequences. However, independent directors can claim exemption from such liability by using the concept of business judgment, as discussed earlier.[22]
B. Negligence and Violation of Memorandum & Articles of Association
According to the Companies Act, directors of a company must exercise extreme caution when performing their duties, and any carelessness on their part would lead to a legal charge.[23] The directors are also required to comply with the rules and regulations stated in the company’s Memorandum and Articles, and any deviation from them not only results in liabilities but also requires the directors to compensate for the loss the company has incurred due to such a breach.[24]
C. Under the Companies Act
The 2013 Act is crucial concerning the liabilities of independent directors since it reduced their liabilities by acknowledging that the responsibilities of executive directors and independent directors cannot be the same. Section 149(12) of the 2013 Act restricts the liabilities of independent directors in cases where they have express knowledge or reasonable opportunity to raise their concerns, as mandated under Schedule IV of the Act.[25] The provision includes:
i) Liability for awareness of actions that violate the law, which covers both express and implied knowledge. Liability on the directors is subjective and takes into account their role and the scope of available information.
ii) The act seeks to impose liability in cases where actions can be traced back to board meetings. Under this provision, directors are required to be alert and informed about every issue being considered by the board. Directors can avoid such liability if they can show that they objected the action that led to the liability.
iii) The section also imposes liability for consent of the act in question. It is essential to understand “connivance,” which traditionally is held to a lower standard and does not require actual consensus ad idem but rather is based on factual inquiry. Liability under this provision requires demonstrating the director’s involvement even though they did not actively consent to it.
iv) The final type of liability discussed in this section is related to a failure to act diligently and perform duties as outlined in Schedule IV of the Act. This type of liability is particularly significant as Schedule IV was specifically created for independent directors and failing to adhere to it can result in serious consequences.
In the Zylog Systems case[26], shareholders filed a complaint with SEBI after the board failed to disclose certain records. SEBI held all directors, including independent ones, accountable for the offense. However, after reviewing the board meeting minutes and seeing that the independent directors had opposed non-payment of dividends and resigned after failing to persuade others, the court absolved them of liability, noting that they had not violated any laws.[27] Similarly, in the case of Satyam Computers, where the chairman manipulated the balance sheet to deceive investors, independent directors were found to have no way of verifying the information and were therefore released from liability.[28]
D. Other Liabilities
Furthermore, besides the liabilities established by the Companies Act and SEBI regulations, there exist various other regulations that direct the actions of company directors, such as circulars released by the RBI, the Minimum Wages Act, and the Negotiable Instruments Act.[29] However, these regulations do not differentiate between independent directors and other directors, which can result in independent directors being held liable for actions in which they had no involvement.[30]
Anomalies with the Current Liability Rules in India
The act and particularly S. 149 (12) do not provide a level playing ground in terms of the benefits and consequential liabilities being bestowed upon the independent directors.[31] The independent directors in India are put to undue and disproportionate liability leading to stepping down of such directors without providing fitting reasons against it.[32] It is accepted that, the people who are appointed as independent directors are generally people with high standing and impeccable character, however the disproportionate liability regime casts significant threat on their reputation in the corporate world.[33]
At this stage it is important to note the inconsistency in the judicial rulings as well as the apex court in Pooja Ravinder Devidasani v. State of Maharashtra has ruled that, “undoubtedly a non-executive director is the custodian of governance of the company, but a person is not liable for all the actions of a company only by the virtue of being a director”.[34] Further, in the case of Sunil Mittal v. CBI the Supreme court stated that in order to hold an official accountable for the actions of the company i) there must be sufficient evidence along with the intention and ii) when the provisions of law itself provide liability for such officials.[35] Similar observations have been reiterated in the cases of National Small Industries[36] and Shiv Kumar Jatia[37], however in practice huge deviation has been observed leading to implication of independent directors without sufficient grounds leading to unjust and disproportionate liabilities.
The stand taken by judiciary cannot be ignored while discussing the existing model of liabilities on independent directors in India. Over the years’ there has been a general practice by Indian courts, by disregarding the precedents, wherein all the directors of the company are implicated and notices are issued. Under statutes such as the Negotiable Instrument Act, 1881 (S. 141), no difference has been carved out for the executive and the independent directors, and every person in charge of the company is implicated. This often leads to issue of notice against all the directors as all of them are made party to the suit.[38] The harm caused to the reputation and goodwill of the director is not accounted for even by the ‘safe harbour’ provisions under S. 149 (12) of the act as it kicks post the notice stage. Further, the protections as mentioned under S. 149 (12) are provided with respect to offences stipulated within the Act itself and not against liability arising from other statutes.[39]
For instance, recently in the matter of Chitra Sharma v. Union of India, the Hon’ble Supreme Court, while issuing orders, failed to appreciate the distinction between the liabilities between an executive and independent director and placed restrictions from leaving the country as well as alienating their property.[40] Similarly, in the matter of Somendra Khosla v. State, accepted the arguments that an independent director is responsible for the daily affairs of the company and therefore denied quashing complaint against the independent director.[41] This decision of the Delhi High Court was based on the verdict of apex court in Standard Chartered Bank v. State of Maharashtra, wherein the top court had allowed issue of summons against directors who were responsible for the daily affairs of the company, who in that case were not the independent directors.[42]
Therefore, it can now be safely assumed that the liabilities on independent directors in India is largely disproportionate to the responsibilities and benefits assigned to them. Even though the law prescribes certain protections and indemnity for the benefit of such independent directors, it was been observed, more often than not, that these safeguards fail to achieve the desired purpose. Even if the monetary losses are taken care of to some extent, the loss of reputation and goodwill cannot be discredited and hence the law in this context needs to evolve.
Independent Directors and Liabilities: Case of USA and United Kingdom
The purpose of conducting a comparative study with the USA and UK is to gain a better understanding of corporate governance before examining the model in question. Additionally, these two countries have taken a leading role in reforming independent director regulations under their corporate governance systems.
USA
In the USA, all directors of a company, regardless of their authority, are responsible for a fiduciary duty.[43] The US Stock Market’s, NASDAQ Listing Rules, and the 2002 Sarabanes-Oxley Rules govern the compliance and liabilities of independent directors. The liabilities of independent directors in the USA are primarily classified based on two considerations: the Due Care Standard and the Business Judgment Rule. This is because independent directors are not expected to have the same level of technical knowledge as executive directors.[44]
The Due Care Standard considers whether an independent director has acted in a manner consistent with that of a reasonable and prudent person in similar situations. Therefore, independent directors are held accountable if they have acted in a grossly negligent way.[45] In the US, courts have kept the threshold for Due Care lower for independent directors compared to executive directors. The Business Judgment Rule presumes that independent directors have acted in a reasonable and diligent manner, with the primary focus on the interests of the company.[46]
Regarding protections granted to independent directors, regulations in the USA provide for indemnity and other exculpatory clauses to excuse individual liabilities in case of contravention of duties assigned to them, though such protections are not mandatory.[47] However, independent directors are not exempt from liabilities if they engage in fraud or act in a self-serving manner.[48]
UK
The regulations that determine the liabilities of independent directors in the UK are the Companies Act, 2006 and the Corporate Governance Code. Unlike in the USA, the only difference between the liabilities of executive directors and independent directors in the UK is related to contractual requirements.[49] The UK model differs from the USA in that the “due care” standard in the UK necessitates a threshold of negligence rather than gross negligence.[50] Additionally, similar to the USA, UK regulations allow for indemnity clauses to be included in contracts.
Conclusion
The importance of independent directors is certain in ensuring transparency and ethical acquiescence. The duties enshrined upon the independent directors under the Schedule IV make it evident that they are supposed to fulfil extremely important functions. However, as discussed in the previous parts, it is often felt that the liabilities casted upon these directors is severely disproportionate to the inducements that are offered to them. Such a set-up dissuades people with reputation and experience to take up the responsibility, and taking the advantage, corporates appoint only those people as independent directors who would not serve the actual purpose, thereby making a mockery of the system.
[1] Sarth N. Mathew, An Optimal Liability Solution for Independent Directors.
[2] The Companies Act, 2013, S. 149.
[3] The Companies Act, 2013, S. 166.
[4] Cadbury, A., Report of the Committee on the Financial Aspects of Corporate Governance (1992).
[5] Id
[6] Financial Express, Satyam scam which toppled India’s fourth largest IT Company from the top slots, available at https://www.financialexpress.com/industry/what-was-satyam-scam-which-toppled-indias-fourth-largest-itcompany-from-the-top-slots/1010389/ (last accessed on 20th March, 2023).
[7] The Companies Act, 2013.
[8] The Companies Act, 2013, S. 149 (6).
[9] The Companies Act, 2013, S. 149 (6) (a).
[10] The Companies Act, 2013, S. 149 (6).
[11] The Companies Act, 2013, S. 149 (6) (e).
[12] Sudhi Ranjan Bagri, Roles Of Independent Directors In Corporate Governance available at https://blog.ipleaders.in/roles-independent-directors-corporate-governance/ ( last accessed on 20th March 2023)
[13] Id
[14] The Companies Act, 2013, Schedule IV.
[15] Family run businesses in India, availble at https://www.familybusinessunitted.com/opinions/perspectives/understanding-family-business-in-indiaperspective/ (last accessed on 20th March, 2023).
[16] Id
[17] Securities and Exchange Board of India Act, 1992.
[18] The Companies Act, 2013.
[19] The Companies Act, 2013, Schedule IV.
[20] Regal (Haastings) Ltd. V. Guliver [1963] Ch 436.
[21] Id
[22] The Companies Act, 2013, S. 166.
[23] The Companies Act, 2013, S. 149 (5).
[24] Id
[25] The Companies Act, 2013, S. 149 (12).
[26] Umakanth Varottil, Minimizing the liability of Directors: SEBI’s order in the Zylog Case, available at https://indiacorplaw.in/2017/06/minimizing-liability-of-directors-sebis.html ((last accessed on 20th March, 2023).
[27] Ashish Bhattacharyya, Satyam: How guility are the independent directors?, Business Standard (29/01/2013), Available at http://www.business-standard.com/article/economy-policy/satyam-how-guilty-are-the-independentdirectors-109011201009_1.html (last accessed on 20th March, 2023).
[28] Id
[29] Independent Directors: Staying mindful of liability, available at https://www.vantageasia.com/independentdirectors-staying-mindful-liabilities (last accessed on 22th January, 2021).
[30] Id
[31] The Companies Act, 2013, S. 149 (12).
[32] Debanshu Mukherjee & Astha Pandey, The Liability Regime for Non-executive and Independent Directors in India: A case for reform, available at https://vidhilegalpolicy.in/research/the-liability-regime-for-non-executive-and-independent-directors-in-india-a-case-for-reform/ (last accessed on 22th January, 2021).
[33] Supra, note 1.
[34] Pooja Ravinder Devidasani v. State of Maharashtra, Criminal Appeal Nos. 2604-2610 of 2014, SLP (CRL) Nos. 9133-9139 of 2010.
[35] Sunil Bharti Mittal v. CBI, Criminal Appeal No. 34 of 2015 (SLP (CRL) No. 2961 of 2013).
[36] National Small Industries v. Harmeet Singh Paintal, Criminal Appeal No. 320-336 of 2010 (SLP (CRL) Nos. 445-461 of 2010).
[37] Shiv Kr. Jatia v. State of NCT of Delhi, Criminal Appeal No. 1263 of 2019 (SLP (CRL) No. 8008 of 2018).
[38] The Negotiable Instruments Act, 1881, S. 141.
[39] Debanshu Mukherjee & Astha Pandey, The Liability Regime for Non-executive and Independent Directors in India: A case for reform, available at https://vidhilegalpolicy.in/research/the-liability-regime-for-non-executive-and-independent-directors-in-india-a-case-for-reform/ (last accessed on 20th March, 2023).
[40] Chitra Sharma v Union of India, MANU/SCOR/49021/2017.
[41] Somendra Khosla v. State, Criminal Misc. No. 3982/2017.
[42] Standard Chartered Bank v. State of Maharashtra, (2016) 6 SCC 62.
[43] Rebecca Grapsas, Clarie Holland & Holly Gregory, Corporate governance in the USA, available at https://www.lexology.com/library/detail.aspx?g=e295afc9-da23-4824-9025-9772e3438ebe (last accessed on 20th March, 2023).
[44] Id
[45] Id
[46] Id
[47] Sections 102 (b)(7), of Delaware Genral Corporation Laws.
[48] Id.
[49] UnitedKingdom Corporate Goveranance Code, 2012 available at https://www.frc.org.uk/directors/corporate-governance/uk-corporate-governance-code (last accessed on 20th March, 2023).
[50] Id
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