♦ The concept which was first introduced in the 1998 CII Report was enthusiastically endorsed by the Kumar Mangalam Birla Committee Report which asserted that the independent directors have “a key role in the entire mosaic of corporate governance” in India. This faith in the person of the independent director has been reflected in various committee reports and regulations and has eventually made its way into the statutory domain in the form of Chapter 11 of the Companies Act, 2013.
♦ The concept was developed in the US where the primary corporate governance concern is the agency problem existing between on one hand, the shareholders who own the company; and on the other, the class of professional managers. If the board meetings are left to be driven by the management, the shareholders will not have much of a say in the running of the company at all. As can be expected, the managers of such companies come to accumulate significant authority, and often pursue their own agendas which are not necessarily associated with those of the investors. It was in the backdrop of this agency problem that the idea of having non-management directors introduced, with the expectation that these directors not only owe to the management but also will check managerial excesses and protect the interests of the shareholders.
BACKGROUND AND RATIONALE
- The concept of Independent Directors (IDs) emerged from the need to have a certain number of directors on the Board who would think and act independently to bring about a healthy balance between the interests of the promoters and other stakeholders including minority and small shareholders. IDs are an important component in the overall framework of Corporate Governance.
- SEBI has over the years, strengthened the institution of IDs through the recommendations of various committees. This institution has thus evolved considerably since 1999, when SEBI had first introduced the concept of Independent Directors based on the recommendations of the Committee on Corporate Governance under the Chairmanship of Shri Kumar Mangalam Birla. The latest amendments emanate from the Committee on Corporate Governance set up under the chairmanship of Shri Uday Kotak in 2017.
- The Ministry of Corporate Affairs (MCA) also introduced the requirement of Independent Directors in the Companies Act of 2013 (“Companies Act”) and even laid down a Code of Conduct for IDs.
- As per the Code of Conduct, IDs 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. Accordingly, the Audit Committee of the board which is responsible for approving related party transactions and for oversight of the financial reporting process and the sanctity of financial information, is mandated to have at least two–third of Independent Directors. Besides, IDs are also 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.
- Despite the above provisions and various measures taken, concerns around the efficacy of independent directors as a part of corporate governance framework continue. There is therefore a need to further strengthen the independence of IDs and enhance their effectiveness in protection of the interest of the minority shareholders, and other functions.
- In this regard, sharper focus is required in the areas of appointment and role of the independent directors. Accordingly, proposals including broadening the eligibility criteria for IDs, the process of appointment / re-appointment and removal of IDs, enhancing transparency in the nomination and resignation of IDs, strengthening the composition of Board Committees, are being placed for public consultation. Additionally, views are also sought on the need for review of remuneration of IDs.
AMENDMENTS PROPOSED BY SEBI IN CONSULTATION PAPER ON ID
The Securities and Exchange Board of India (Sebi) had laid down the following proposals to make independent directors more powerful that formed a part of a consultation paper and was put up for public comments on Sebi’s website till April 1, 2021
♦ DEFINITION OF INDEPENDENT DIRECTORS
- Regulation 16 of SEBI LODR Regulations set out certain objective conditions (enclosed at Annex-1) for determination of independence of a director. These conditions include areas of relationship of self and of relatives (including material pecuniary relationship)with the listed entity, its promoter or directors, its holding, subsidiary or associate companies and shareholding in the listed entity;
- One of the eligibility conditions is that persons who have been employees/KMPs or his/her relatives have been KMPs of the listed entity / its holding company / subsidiary / associate company in the past 3 years, cannot be appointed as IDs. In order to establish the independence of the person it is important that KMPs or employees of companies forming part of the promoter group and relatives of such KMPs should also be excluded from acting as independent directors;
- Currently, as per SEBI LODR Regulations, a cooling-off period has been prescribed for the person to be eligible for acting as an ID, inter-alia as follows:
- Cooling-off period of 3 years in case the person has been an employee / KMP or his / her relative has been a KMP of the listed entity / its holding company / subsidiary / associate company;
- Cooling-off period of 2 years in case of a material pecuniary relationship between person or his / her relative and the listed entity / its holding company / subsidiary / associate company. Since, this cooling off period is not uniform, there is a need to harmonize the same.
It is proposed that KMPs or employees of promoter group companies, cannot be appointed as IDs in the company, unless there has been a cooling-off period of 3 years. The said restriction shall also extend to relatives of such KMPs for the same period. The prescribed cooling-off period for eligibility condition at 3(b) above shall be harmonized to 3 years.
♦ APPOINTMENT AND RE-APPOINTMENT PROCESS OF INDEPENDENT DIRECTORS
- As per the extant regulatory norms for appointment of IDs, the Nomination and Remuneration Committee (“NRC”) proposes a person as ID, who is then appointed by the Board. Subsequently, shareholders approve the appointment through an ordinary resolution (special resolution in case of re-appointment);
- As may be seen from the above, the present system of appointment of IDs may be influenced by the promoters –in recommending the name of ID and in the approval process by virtue of shareholding. This may hinder the “independence” of IDs and undermine their ability to differ from the promoter, especially in cases where the interests of promoter and of minority shareholders are not aligned. Additionally, considering that the primary duty of Independent Directors is to protect the interest of minority shareholders, there is a need for minority shareholders to have greater say in the appointment / re-appointment process of IDs;
- Some jurisdictions, like Israel, have provisions for appointment of independent directors by minority shareholders. In UK, for premium listed companies which have a controlling shareholder, a dual voting structure has been adopted whereby the appointment of independent directors must be approved both by the shareholders as a whole and by the independent shareholders. If either of the resolutions fails, but the company still wants to propose the person as an independent director, it is allowed to put the matter to a second vote of all shareholders (including the controlling shareholder(s).
- Appointment and re-appointment of IDs shall be subject to “dual approval”, taken through a single voting process and meeting following two thresholds:–
i. Approval of shareholders.
ii. Approval by ‘majority of the minority’ (simple majority) shareholders. ‘Minority ‘shareholders would mean shareholders, other than the promoter and promoter group.
The approval at point (i) above, shall be through ordinary resolution in case of appointment and special resolution in case of re-appointment.
- If either of the approval thresholds are not met, the person would have failed to get appointed / re-appointed as ID. Further, in such case, the listed entity may either:
i. Propose a new candidate for appointment / re-appointment or
ii. Propose the same person as an ID for a second vote of all shareholders (without a separate requirement of approval by ‘majority of the minority’), after a cooling-off period of 90 days but within a period of 120 days. Such approval for appointment/re-appointment shall be through special resolution and the notice to shareholders will include reasons for proposing the same person despite not getting approval of the shareholders in the first vote.
♦ REMOVAL OF INDEPENDENT DIRECTORS
- At present, an ID can be removed through a simple majority in the first term and through a special resolution in case of second term, after giving him a reasonable opportunity to be heard. Since, the ID may be removed through a simple majority, the promoter may have significant influence in the removal process by virtue of shareholding;
- Consistent with the greater say of the minority shareholders proposed in the appointment of an ID, minority shareholders, should also be given a say in the removal process of IDs as well.
- Removal of IDs shall be subject to “dual approval”, taken through a single voting process and meeting following two thresholds:
- Approval of shareholders.
- Approval of ‘majority of the minority’ (simple majority) shareholders. ‘Minority ‘shareholders would mean shareholders, other than the promoter and promoter group.
The approval at point (i) above, shall be through ordinary resolution in case of removal in the first term and special resolution in case of removal in the second term.
- If either of the approval thresholds are not met, the person would have failed to get removed as an ID. In such case, the removal of such ID may again be proposed through a second vote of all shareholders (without a separate requirement of approval by ‘majority of the minority’), after a cooling-off period of 90 days but within a period of 120 days. Such approval for removal shall be through special resolution and the notice to shareholders will include reasons for proposing the removal again despite not getting approval of the shareholders in the first vote.
♦ ENHANCING AND BRINGING IN MORE TRANSPARENCY IN THE ROLE OF NRC
At present, all members of the NRC should be non-executive, with a majority of independent directors. Further, LODR Regulations prescribe the following role of the nomination and remuneration committee (NRC) in the matter of appointment of IDs:
a. Formulation of the criteria for determining qualifications, positive attributes and independence of a director
b. Identifying persons who are qualified to become directors in accordance with the criteria laid down, and recommend to the board of directors for their appointment and removal.
c. Whether to extend or continue the term of appointment of the independent director, on the basis of the report of performance evaluation of independent directors.
While the law requires NRC to lay down detailed criteria of qualifications and attributes for directors, apparently there is a lack of transparency in the process followed by NRC. There is therefore, a need to prescribe disclosures regarding the process followed by NRC for selection of candidates for the post of ID.
- The following procedure shall be followed by NRC for selection of candidates for the role of ID –
a. 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 fora particular appointment.
ii. The person who is recommended to the Board for appointment as ID 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
b. 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.
- Composition of NRC may be modified to include 2/3rdIDs instead of majority of IDs.
♦ PRIOR APPROVAL OF SHAREHOLDERS FOR APPOINTMENT OF IDS
- As per the current practice, companies appoint independent directors as additional directors, subject to approval of the shareholders at the next general meeting. It is therefore possible that a person gets appointed as an additional independent director, just after an AGM and then serves on the board of directors, without shareholder approval, till the next AGM;
- In the case of vacancy of an Independent Director due to resignation or removal, existing provisions provide a time-period of up to 3 months to appoint another director. However, the approval of shareholders would be taken at the next AGM, which could potentially be up to another 9 months away;
- As mentioned above, there can be a significant time gap between the appointment of an independent director and approval of shareholders, which is not in the best interest of especially the minority shareholders. There have been cases in the past where the shareholders have rejected the appointment of IDs while these IDs had served on the Board for few months;
- Reduction/ elimination of this gap may give more say to shareholders in the appointment process
Independent Directors shall be appointed on the board only with prior approval of the shareholders at a general meeting. In case, a casual vacancy arises due to resignation / removal / death / failure to get re-appointed etc., the approval of shareholders should be taken within a time period of 3 months.
♦ RESIGNATION OF INDEPENDENT DIRECTORS.
- As per current provisions of LODR, the resigning ID within 7 days of his resignation, has to disclose to stock exchanges, detailed reasons for the resignation along-with a confirmation that there is no other material reason for resignation other than those already provided;
- It is observed that IDs often resign for reasons such as pre-occupation, other commitments or personal reasons and then join the boards of other companies. There is, therefore, a need to further strengthen the disclosures around resignation of Independent Directors;
- Cases have also been observed where IDs have resigned and then joined the same company as an executive director. While there may be valid reasons for transition from an ID to executive director, such instances where an ID knows that he/she may move to a larger role in the company in the near future, may practically lead to a compromise in independence.
- The entire resignation letter of an ID shall be disclosed along with a list of his/her present directorships and membership in board committees;
- If an ID resigns from the board of a company stating reasons such as pre-occupation, other commitments or personal reasons, there will be a mandatory cooling-off period of 1 year before the ID can join another board;
- It is proposed that there should be a cooling-off period of 1 year before a director can transition from an ID to a whole-time director.
♦ COMPOSITION OF THE AUDIT COMMITTEE
The LODR Regulations cast specific responsibilities on the Audit Committee (two-thirds of its members are independent directors), to review financial statements, scrutinize inter-corporate loans & investments and valuation of undertakings and assets of the listed entity, wherever applicable. In case of related party transactions, prior approval of the Audit Committee is mandatory. SEBI has mandated that a committee of Independent directors should give their recommendations on open offers and schemes of arrangements.
Considering the importance of the Audit Committee with regard to related party transactions and financial matters, it is proposed that audit committee shall comprise of 2/3rd IDs and 1/3rd Non-Executive Directors (NEDs) who are not related to the promoter, including nominee directors, if any.
♦ REVIEW OF REMUNERATION
- As per the Companies Act, apart from reimbursement of expenses, IDs are permitted to be paid sitting fees (max 1 lakh) and profit linked commission within an overall limit. Further, in terms of both Companies Act and LODR Regulations, IDs cannot be given stock options;
- While there are concerns that a large remuneration may compromise the independence of ID, lesser compensation may also not attract competent IDs on the boards of the listed entities;
- In this regard, one area of debate is removal of profit linked commission and increase in sitting fees paid to Independent Directors. This is with a view that the remuneration to IDs should be on the basis of their value and time-commitments to the company, without linking the same to the profits of the company. This would lead to IDs getting a fixed fee, without having any stake in the long-term growth of the company;
- On the other hand, linking remuneration to profit or performance linked commission ensures that IDs have “skin-in-the-game”. The concern with this approach -that profit or performance linked commission may encourage short-termism and lead to conflicts, may be addressed by permitting ESOPs to IDs (instead of profit linked commission) with a long vesting period of say, 5 years. ESOPs are a commonly used method of remuneration for employees, especially in technology and start-up companies, since it ensures alignment of interests of the company and of the employees;
- Since any modification in the existing remuneration structure of IDs will require changes to the Companies Act, based on the comments received and further analysis of the same, appropriate recommendations will be sent to the Ministry of Corporate Affairs (MCA) for their consideration.
A separate body needs to be constituted under the Ministry of Corporate Affairs to oversee the functioning of independent director. The funding required can be collected as an annual cess and subscription from the corporate sector. Hopefully, more involvement and micromanagement will deliver the desired results.
We will need a large number of competent independent directors to meet the demand of the next decade to man several positions from companies to trusts, NGOs, and organizations where public interest is involved.
Strengthening of the audit committee, risk committee and the nomination and remuneration committee may only mean the independent directors chairing them need to be strengthened. The eligibility, role responsibility, and the authority of the independent director need to be reformed/ strengthened.
Absolute care is taken to prepare this article; however, inadvertently if any errors occur then the Author shall not be held responsible for any such cause. The Content published is only for educational purpose and shall not be construed as the rendering of any Professional Advice in any manner whatsoever. Readers must exercise their own judgment and refer the original source before any implementation. Further, the Content is an original work of the author and may be used only after written permission.
Research Associate & Start-up Consultant
Jaya Sharma & Associates
Jaya Sharma & Associates