Strengthening the Statutory Regime for Independent Directors

Introduction

Independent Directors hold paramount position in the Board of Directors since they are donned with the responsibility of upholding the interest of the stakeholders and are expected to bring in independent judgement on the Board’s deliberations especially on issues of strategy, performance, risk management, resources, key appointments and standards of conduct as well as bring an objective view in the evaluation of the performance of board and management.

SEBI’s Consultation Paper

SEBI has on 01 March 2021 released a consultation paper on review of regulatory provisions related to Independent Directors. The requirement of Independent Directors was introduced by Ministry of Corporate affairs (‘MCA’) via the Companies Act 2013 (‘Act’) wherein all listed entities and specified public entities are under obligation to appoint prescribed number of Independent Directors on the Board of Directors. Further, a detailed code of conduct for Independent Directors was also introduced by MCA under the Act wherein it is specified that independent directors are expected to pay specific attention on the integrity of financial information and on related party transactions along-with safeguarding the interests of the minority shareholders and for this constitution of Audit Committee is mandated under section 177. Furthermore, various provisions relating to independent directors are also incorporated by the Securities and Exchange Board of India (‘SEBI’) in the Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements) Regulations, 2015 (‘LODR’) in line with the Act. Despite the above provisions and various measures taken, concerns around the efficacy of independent directors as a part of corporate governance framework continued. This is why SEBI felt a need to further strengthen the independence of independent directors and enhance their effectiveness in protection of the interest of the minority shareholders and other functions. This article deals with all the proposals comprehensively beginning from the extant provisions to dealing with the issues and analysing the proposals recommended by SEBI.

1. Eligibility for appointment as Independent Director:

SEBI has proposed to enlarge the scope of eligibility criteria with respect to appointment of independent director in a listed entity. Before proceeding with the proposal, lets first contemplate the eligibility criteria as specified in the extant regulation 16(1)(b) of LODR:

“Independent director” means a non-executive director, other than a nominee director of the listed entity:

i. who, in the opinion of the board of directors, is a person of integrity and possesses relevant expertise and experience;

ii. who is or was not a promoter of the listed entity or its holding, subsidiary or associate company or member of the promoter group of the listed entity;

iii. who is not related to promoters or directors in the listed entity, its holding, subsidiary or associate company;

iv. who, apart from receiving director’s remuneration, has or had no material pecuniary relationship with the listed entity, its holding, subsidiary or associate company, or their promoters, or directors, during the two immediately preceding financial years or during the current financial year;

v. none of whose relatives has or had pecuniary relationship or transaction with the listed entity, its holding, subsidiary or associate company, or their promoters, or directors, amounting to two per cent. or more of its gross turnover or total income or fifty lakh rupees or such higher amount as may be prescribed from time to time, whichever is lower, during the two immediately preceding financial years or during the current financial year;

vi. who, neither himself, nor whose relative(s) —

(A) holds or has held the position of a key managerial personnel or is or has been an employee of the listed entity or its holding, subsidiary or associate company in any of the three financial years immediately preceding the financial year in which he is proposed to be appointed;

(B) is or has been an employee or proprietor or a partner, in any of the three financial years immediately preceding the financial year in which he is proposed to be appointed, of —

(1) a firm of auditors or company secretaries in practice or cost auditors of the listed entity or its holding, subsidiary or associate company; or

(2) any legal or a consulting firm that has or had any transaction with the listed entity, its holding, subsidiary or associate company amounting to ten per cent or more of the gross turnover of such firm;

(C) holds together with his relatives two per cent or more of the total voting power of the listed entity; or

(D) is a chief executive or director, by whatever name called, of any non-profit organisation that receives twenty-five per cent or more of its receipts or corpus from the listed entity, any of its promoters, directors or its holding, subsidiary or associate company or that holds two per cent or more of the total voting power of the listed entity;

(E) is a material supplier, service provider or customer or a lessor or lessee of the listed entity;

vii. who is not less than 21 years of age.

viii. who is not a non-independent director of another company on the board of which any non-independent director of the listed entity is an independent director.

Issues: As per extant Regulation 16(1)(b)(vi)(A) of LODR in order to be appointed as an independent director in a listed entity, a person has to ensure that neither he nor his relative is holding or has held in the past the position of Key Managerial Personnel or employee in the listed entity or its holding, subsidiary or associate company in any of the three financial years immediately preceding the financial year in which he is proposed to be appointed. From the very look of this provision, it can be inferred that it is wide enough in respect to exclusion of maximum possible people, who are associated with the listed entity, from the eligibility requirement. However, the same was considered not enough and in order to establish complete independence of the person, SEBI has proposed to widen the scope of the exclusion for the eligibility requirement. Further, in regulation 16(1)(b)(iv) a person is ineligible if he has a material pecuniary relationship with the listed entity, its holding, subsidiary or associate company, or their promoters, or directors, during the two immediately preceding financial years or during the current financial year. The period of two years is not in alignment with the period of 3 years as prescribed in regulation 16(1)(b)(vi)(A).

SEBI’s Proposal: SEBI has proposed that KMPs or employees of promoter group companies or relatives of such KMPs shall be ineligible to be appointed as independent director unless there has been a cooling-off period of 3 years. Further, in order to harmonise regulation 16(1)(b)(vi)(A) and 16(1)(b)(iv), it is proposed to change the cooling off period under the latter regulation from 2 years to 3 years.

2. Dual Approval for Appointment and re-appointment process of Independent Directors:

SEBI has proposed to strengthen the compliance regime relating to appointment and re-appointment of independent directors. As per the extant provisions i.e section 149(10) of the Act, shareholders approval via ordinary resolution in case of appointment and special resolution in case of re-appointment is required.

Issues: An independent director is an indispensable part of the Board of Directors and the existing system of appointment/re-appointment is observed to be influenced by promoters in the manner that they are the ones recommending the name of independent director and are also participating in the approval process by virtue of their shareholding. This may hinder the “independence” of independent directors and undermine their ability to differ from the promoter, especially in cases where the interests of promoter and of minority shareholders are not aligned. Further, an independent director’s utmost role is to protect the interest of minority shareholders, therefore, there is a need for minority shareholders to have greater say in the appointment / re-appointment process of independent directors. In the light of the above it was perceived by SEBI that such appointment should be thoroughly discussed by public shareholders and for this single approval might wouldn’t suffice the purpose and therefore, the concept of dual approval is proposed in respect to both appointment and re-appointment.

SEBI’s Proposal: As per SEBI’s proposal, first normal approval of shareholders, ordinary resolution for appointment and special for re-appointment, will be obtained. Thereafter, approval by majority of the minority shareholders will be obtained. Here, Minority shareholders would mean shareholders, other than the promoter and promoter group. If either of the approval thresholds are not met, the person would become ineligible for appointment however, there is one catch in the sense that listed entity can propose either a new person or the same person (who failed to get dual approval of shareholders) for a second vote of all the shareholders, promoter and non-promoter, after a cooling-off period of minimum 90 days and maximum upto 120 days and the notice to shareholders will include reasons for proposing the same person despite not getting approval of the shareholders in the first vote.

3. Dual Approval for Removal of Independent Directors:

Alike the appointment/re-appointment, SEBI has proposed to strengthen the compliance regime relating to removal independent director as well. As per proviso to section 169(1) an independent director can be removed by a company by passing ordinary resolution and in case of re-appointed independent director, by passing special resolution.

Issues: Again, just as the appointment/re-appointment of independent directors is influenced by the promoters, their removal also come under the ambit of promoters influence. A resolution moved for removal of an independent director can not be dealt with lightly since it is the interest of minority shareholders which would be at stake. There must be some concrete reasons behind moving resolution for removal of an independent director and the same must be discussed and deliberated diligently.

SEBI’s Proposal: It was perceived by SEBI that consistent with the greater say of the minority shareholders proposed in the appointment of an independent director, minority shareholders, should also be given a say in the removal process of independent director as well. Therefore, SEBI has proposed concept of dual approval for removal as well. The process of dual approval for removal is similar to that of appointment/re-appointment.

4. Prior approval of shareholders for appointment of Independent Directors:

The prerogative of confirming the appointment of an independent director, as recommended by Board of Directors, rest with the shareholders. However, it is observed that as a part of general corporate practice, board of directors appoint a person as additional independent director and then recommend such person to the shareholders for his regularization as independent director. As per regulation 161 (1) of the Act “the articles of a company may confer on its Board of Directors the power to appoint any person, other than a person who fails to get appointed as a director in a general meeting, as an additional director at any time who shall hold office up to the date of the next annual general meeting or the last date on which the annual general meeting should have been held, whichever is earlier”. Further, as per section 161(4) of the Act and regulation 25(6) of LODR any vacancy at the position of independent director is required to be filled by the board not later than 3 months from the date of vacancy and the concerned appointment is required to be confirmed by shareholders in the general meeting.

Issues: Here the underlying issue is that an additional director holds office till the commencement of immediately next Annual General Meeting (AGM) and a person who is appointed as additional independent director will keep on holding the office without shareholders approval till the next AGM. An AGM is required to be convened within 6 months of the closure of financial year i.e 30 September. Suppose if a person is appointed as additional independent director immediately after AGM i.e. on 01 October 2020, then he is eligible to serve upto 30 September 2021 without the approval of shareholders and this was never the intention of legislature. Further, as far as filling up of casual vacancy of independent director is concerned, the same is done by board within 3 months from the date of vacancy. Now, the issue here is that while the vacancy is filled by the board the same is confirmed by the shareholders only at the immediate next general meeting. This creates a huge gap between the two approvals and is impairing the interest of minority shareholders especially in the case where shareholders decide to refuse the appointment of such person in the general meeting.

SEBI’s Proposal: Therefore, in the light of the above it is proposed that a person can be appointed as independent director directly by shareholders only and the board of directors are not allowed to appoint any person as additional director in independent capacity. Further, SEBI has proposed that any casual vacancy arising at the position of independent director is required to filled by the shareholders within 3 months.

5. Resignation of Independent Directors:

As per section 168 (1) a director may resign from his office by giving a notice in writing to the company and the Board shall on receipt of such notice take note of the same and the company shall intimate the Registrar in such manner, within such time and in such form as may be prescribed and shall also place the fact of such resignation in the report of directors laid in the immediately following general meeting by the company. Further, as per Clause 7(A) of Part A of Schedule III of LODR, in case of resignation of an independent director of the listed entity, relevant stock exchanges are required to be disclosed the detailed reasons for the resignation of independent directors as given by the said director.

Issues: In this regard SEBI observed that usually independent directors resign from one company citing personal reasons and join the board of another company as executive director and this transition has a seriously implication on their independence. The extant regulations do not provide for any provision governing the transition of the role of a person as an independent director to executive director.

SEBI’s Proposal: Therefore, SEBI has proposed a cooling off period of 1 year as a measure to control this transition. It is proposed that where a person resigns from the position of independent director in a company then he will become ineligible for a period of one year to be appointed as a Whole Time Director in another company. It is further proposed that if an independent director resigns from the board of directors of a company stating reasons such as preoccupation, other commitments or personal reasons, then there will be a mandatory cooling-off period of 1 year before such person can join another board. Further, it is also proposed that the resignation letter of an independent director should also be accompanied by a list of his/her present directorships and membership in board committees in order to ensure more transparency.

6. Composition of the Audit Committee:

As per extant regulation 18 of LODR, an audit committee of a listed entity is required to be constituted with atleast three members and two-third of the total members of the committee should be independent directors. Further, as per section 177 (2) of the Act the audit committee has to comprise of minimum 3 directors with majority of independent directors in the constitution.

Issues: While majority or two-third of the members, as the case may be, are to be independent, the remaining one-third could be executive or non-executive directors. An audit committee is bestowed with the responsibility of reviewing financial statements, scrutinizing inter-corporate loans & investments and valuation of undertakings and assets of the listed entity, wherever applicable. Further, in case of related party transactions, prior approval of the audit committee is mandatory. Therefore, it is important that this committee consists of only directors who are not executive in nature in order to ensure complete separation from the whole-time directors who might influence the decisions of the committee.

SEBI’s Proposal:  Therefore, it is proposed by SEBI that the remaining one-third members in audit committee of a listed entity should be non-executive directors who are not related to the promoters, including nominee directors.

7. Strengthening the role of NRC in selecting candidates for the role of Independent director:

NRC plays a major role in selecting and recommending right candidates to the company therefore, it is perceived that a full-fledged process of selection of independent directors by NRC should be incorporated in LODR. Further, as per regulation 19(1)(c) LODR and section 178(1) atleast fifty percent members of NRC shall be independent directors.

Issues: The remaining fifty percent members of NRC have the capability to influence the selection process especially when they are or related to promoter or promoter group. Further, both the Act and regulations provide that there must be a robust policy on selection and remuneration of directors and that before recommending any person to the board of directors, NRC has to make sure that the said person qualifies in terms of required skills, qualification, experience etc. but still there is a lack of transparency in the process followed by NRC. Furthermore, there is a requirement with respect to disclosure of the skills, experience, knowledge possess by the proposed appointee in the notice to the shareholders however, there is no provision as to disclosure of the source from where the proposed appointee was considered.

SEBI’s Proposal:  SEBI has proposed a full-fledged procedure to be followed by NRC for selecting a candidate for the role of independent director:

Process for shortlisting of the candidate

i. For each appointment, the NRC shall evaluate the balance of skills, knowledge and experience on the board. In the light of this evaluation, a description shall be prepared of the role and capabilities required for a particular appointment.

ii. The person who is recommended to the Board for appointment as independent director should have the capabilities identified in this description.

iii. For the purpose of identifying suitable candidates, the committee may:

• Use services of an external agencies;
• Consider candidates from a wide range of backgrounds, having due regard to diversity and
• Consider the time commitments of the appointees.

Disclosures to be made to shareholders

The notice for appointment of director shall include the following disclosures:

i. Skills and capabilities required for the appointment of the ID and how the proposed individual meets the requirement of the role.

ii. Channels used for searching appropriate candidates. In case, one of the channels is ‘recommendation from a person’, the category of such person (viz. promoters, institutional shareholders, directors (non-executive, executive, ID) etc) shall be disclosed.

Further, SEBI has proposed to increase the limit of independent directors in the NRC committee to two-third.

8. Remuneration and Employee Stock Option Plan (ESOPs):

As per section 149(9) of the Act, an independent director like any other director is eligible to receive sitting fee of an amount upto INR 1 lakh for participating in board meetings and other committee meetings and profit related commissions as may be approved by the members. However, both Act via section 149(9) and LODR via regulation 17(6)(d) strictly prohibit a company from granting of ESOPs to an independent director since an independent director is an independent judgment body and not employee of the company.

Issues: Currently, commission that an independent director receives is based on the profits of a company in a particular year. It is noted by SEBI that the role of the independent director is to offer independent judgment with respect to the performance of and important decisions taken for the company and it would not be feasible if their income is linked with profits as the same might encourage short termism and lead to conflict. It was perceived by SEBI that any commission paid to an independent director should be based on their values and time commitment in the company. Their performance and not the profits in the company should be a determinant factor. Further, it is equally important to ensure that the salary or commission incentive should not be such which is repulsive to the existing independent directors and the proposed appointee.

SEBI’s Proposal: SEBI has proposed that ESOPs should be allowed to be granted to these directors with a vesting period of 5 years which is considered feasible enough as the vesting period will be same as their tenure and this would discourage talent from leaving and also boost their morale as well. Further, commission based on profit should be disallowed and value linked incentives should be introduced.

Conclusion

By introducing the aforementioned proposals, SEBI has proved that it is no longer just hovering around the idea of strengthening the regime of corporate governance. The paramount objective of introducing this proposal is to uplift the rights and confidence of minority shareholders which are currently being exploited by the majority. Proposal as to increasing the participation of minority shareholders in decision making with respect to appointment, re-appointment and removal of independent directors would definitely restrict the promoter shareholders from influencing the process. Further, increased disclosures will promote great transparency and accountability. While there have been a lot of arguments that the concerned proposals are too stringent and the increased transparency, accountability and disclosure requirement will discourage not only the company from appointing more independent directors on board but also affect the will of the proposed appointees. However, these arguments are extraneous when it comes to protecting the interest of minority shareholders and fortifying the regime of corporate governance.