Indian Companies and Independent Directors

Investments made by an investor in a company are on the basis of investor confidence in the strong foundation and future of the company as well as the management of the company. The investors strongly believe that the management will not engage in any untoward practice that will not ultimately harm their investment. Such investor confidence was eroded by many corporate scams that came to light in the United States of America during 2001-02. Some of these scams involved companies of repute such as Enron and WorldCom which deprived the shareholders of millions of dollars.

Enron cleverly manipulated its books of account to hide billions of dollars in debt from failed deals and projects. As a result shareholders failed to ascertain the net worth of the company and invested heavily in the company, thereby resulting in a rise of market value of its shares. When the scam was unearthed, shareholders lost colossal amounts of money. The scam came as a big blow to investor confidence all over the world. It highlighted the need for urgent measures to be taken for transparency in companies and revive investor confidence in the corporate world.

With the object to “re-establish investor confidence in the integrity of corporate disclosures and financial reporting” [1] the US lawmakers enacted the ‘Public Company Accounting Reform and Investor Protection Act’ (in the Senate) and ‘Corporate and Auditing Accountability and Responsibility Act’ (in the House) and commonly called Sarbanes–Oxley Act, Sarbox or SOX. It provided for the inception of the Public Company Accounting Oversight Board (PCAOB), charged with overseeing, regulating, inspecting and disciplining accounting firms in their roles as auditors of public companies. The act also covered issues such as auditor independence, corporate governance, internal control assessment, and enhanced financial disclosure.

A committee was appointed by NYSE to recommend certain guidelines pertaining to corporate governance. The guidelines also included the concept of independent directors. The guidelines were as under:

Independent directors must comprise a majority of a board.

Listed companies must have an audit committee, a nominating committee and a compensation committee, each comprised solely of independent directors.

For a director to be deemed “independent,” the board must affirmatively determine the director has no material relationship with the listed company (directly or as a partner, shareholder or officer of an organization that has a relationship with the company.

Independence also requires a five-year “cooling-off” period for former employees of the listed company, or of its independent auditor; for former employees of any company whose compensation committee includes an officer of the listed company; and for

Immediate family members of the above. [2]

The very purpose behind appointing independent directors is to put checks and balances on each and every activity of the company and bring independence, impartiality and wide experience.

Need for Independent Director’s in India:

In wake of the financial scandals in the United States of America, the need for measures of corporate governance was felt in India. This was fulfilled by the concept of ‘Independent Director’ (ID) as influenced by the US regulations for Corporate Governance.

It was realized that there is a very significant difference between Indian managements, and managements in the US and the rest of the developed world. More than 75 per cent of large listed Indian companies are family-owned, in which a family has a significant (30 per cent upwards) shareholding in the company.

In a company managed by “owners”, there is a very strong motivation for managements to work for a long-term share price increase, i.e. long-term earnings increase, because the family’s prosperity and reputation ride on the prosperity and ethical dealings of the company.

In a competitive market situation, the real controls on management come from the marketplace. Managements (that is promoters) can’t be unfair to any shareholder, including the small shareholder and expect to go unpunished.

If this were to be true, then the ownership structure of Indian companies should, ipso facto, eliminate agency conflicts. However, decades-long experience points to an even more serious problem, the self-seeking behavior and pursuit of private gains of control. How else can one explain the phenomenon of promoter-run companies falling sick by the day, even as the promoters prosper?

Today, obviously all the value destruction has been forced, perhaps to a great extent by the lenders, on the non-promoter shareholders and even on the employees. Indian company managements, with exceptions, have made an art of self-dealing, self aggrandizement, at the cost of the companies they control and at the cost of non-promoter stakeholders, through a variety of means, such as purchases, sales and diversification.

But whether that is something that the independent directors can successfully encounter needs to be seen. With the promoters having the controlling shareholding and for all practical purposes, it is the promoter who actually appoints the director, independent or otherwise, how independent can the independent director truly be. In the current scenario, this entire regime seems redundant and in fructuous.

Evolution of the concept of Independent Directors in India:

The concept of “Independent Director” was first introduced in the Indian corporate arena through the Kumar Manglam Birla Committee, formulated by SEBI, to start up reforms in the area of Corporate Governance. It soon found entry into corporate books, after Clause 49 was incorporated in Listing Agreement by SEBI in 2001. The Birla Report stipulated, “Independent Directors are directors who apart from receiving directors’ remuneration do not have any other material pecuniary relationship or transactions with company, its promoters, its management or its subsidiaries, which in the judgement of the board may affect their independence of judgement” [3] . In other words the committee defined the relationship of an Independent director with respect to a company.  In the background of Enron debacle and sequel to SOX in US (discussed below), Ministry of Company Affairs (MCA, then known as DCA) then constituted, the Naresh Chandra Committee, which gave corporate governance some more thought.

Though the periphery of the committee was restricted to audit and auditors, it brought some new thoughts to institution of IDs. It recommended IDs should not be less than fifty percent of the board. Nominee directors of lending institutions should be considered as independent. It also provided impetus to ID remuneration, training and recommended to exempt them from criminal and civil liabilities i.e. personal liabilities.

In 2003, SEBI constituted the Narayan Murthy Committee with the terms similar to that of Chandra Committee, whose recommendations were incorporated in the Clause 49 by amending it in 2004.

The Murthy report adopted the same definition of IDs as formulated by the Chandra Committee, however, without the condition of nine-year term. It also pondered on the qualification and remuneration of ID and stressed on the need for evaluating the performance of non-executive directors. The committee rejected the recommendation of the previous Chandra Report of treating nominee directors of financial institutions at par with ID [4] .

Sequel to implementation of Murthy committee recommendation in Clause 49, MCA constituted another committee in December 2004 under the Chairmanship of Shri J. J. Irani, to give Corporate Governance (CG) a legislative stamp by revamping the Companies Act, 1956.The Irani Committee came up with several recommendations in relation to the IDs that were in conflict with the extant Clause 49 and/or the views of the Murthy Committee, e.g. the mandatory requirement of IDs to constitute one-half of the Board be weakened to one-third of the total members of the Board. The present CG framework encompassing the ID is through Clause 49 based on the Murthy Report.

It has been decided in Central Government Vs. Sterling Holiday Resorts (India) Ltd. and Ors [5] . that “the Board of directors should be strengthened by appointing independent directors”.

Who are Independent Directors:

Prior to the amendments recommended by the Murthy committee, the definition of the ID under clause 49 was as under:

‘Independent Director’ means a director who apart from receiving director’s remuneration, does not have any material pecuniary relationships or transactions with the company, its promoters, its senior management or its holding company, its subsidiaries and associated companies;

The aforementioned committee broadened the concept of independent directors by suggesting an amendment in the definition. The amendments proposed by the committee were incorporated by SEBI in clause 49 vide its circular dated 26th August, 2003, however no corresponding changes were brought about in the related sections of the Companies Act. The improved definition of ID stands as under:

Independent Director is one who:

apart from receiving director’s remuneration, does not have any material pecuniary relationships or transactions with the company, its promoters, its senior management or its holding company, its subsidiaries and associated companies;

is not related to promoters or management at the board level or at one level below the board;

has not been an executive of the company in the immediately preceding three financial years;

is not a partner or an executive of the statutory audit firm or the internal audit firm that is associated with the company, and has not been a partner or an executive of any such firm for the last three years. This will also apply to legal firm(s) and consulting firm(s) that have a material association with the entity.

is not a supplier, service provider or customer of the company. This should include lessor-lessee type relationships also; and

is not a substantial shareholder of the company, i.e. owning two percent or more of the block of voting shares [6]

Explanation

a. “Management” shall mean personnel of the company who are members of its core management team excluding Board of Directors. Normally, this would comprise all members of management one level below the executive directors, including all functional heads.

b. “Related” shall be interpreted to mean a “relative” as defined in section 2(41) and section 6 read with Schedule IA of the Companies Act, 1956. Nominee directors appointed by an institution which has invested in or lent to the company shall be deemed to be independent directors

IDs are tasked with the protection of the interest of the shareholders. A comparison between the two definitions reveal that the amended definition elucidates on relationships that an independent director must not have with the company since there might arise a possibility of conflict of interest on the part of the ID with respect to the shareholders.

The sense of the definition of independent director is, that a director who disseminates accurate information about the company and maximally facilitates access to information to all shareholders of the company. He shall endeavour to make reasoned judgments on the matters of the company keeping in view the best interests of the company and of the stakeholders. A person must expresses readiness to be appointed as an independent director, and in doing so must work with the rest of the board in promoting company transparency. It is also essential that he must have an even handed attitude towards the interests of all the shareholders and autonomous monitoring of the company’s performance, independent of both the major shareholders and the company management. The difference in the nature of these officers makes it obvious as to why the courts have been imposing varying degrees of responsibility on them.

Role and Liability of Independent Directors:

It has been continuously discussed as to whether the independent directors are required to contribute to the development of corporate strategy, reviewing the performance of management or whether their primary role is to protect the interests of the public shareholders by opposing questionable management policies and establishing adequate controls against unjust enrichment by the promoters and the management.  While a business advisory role may sound ideal, it may not be practically achievable as independent directors are not in charge of executive functions, not privy to the day-to-day affairs and in practice discharge their duties only at the meetings of the board.

The Independent Directors have a fiduciary responsibility towards the company and by law the Independent directors may face civil and criminal liability for their acts and omissions. The role of Independent Directors on the Board of a company came under scrutiny once again after the Satyam fiasco where the Serious Fraud Investigation Office (SFIO) had filed seven cases against eleven ex-directors (including IDs) of Satyam. The arrest by the AP government of the Independent Director of Nagarjuna Finance in the alleged involvement of repayment of public deposits worsened the situation.

The Satyam fiasco has raised questions over the responsibilities and liabilities of the IDs. Moreover in the Bhopal gas tragedy verdict the court held Keshub Mahindra, ex-chairman, Union Carbide India, guilty and sentenced him to two years of imprisonment. All this created a fear psychosis in the mind of ID. Following these events, nearly 340 IDs have resigned from their post. Many people are now not advent to accept the post of ID and tarnish their reputation.

Though, the Companies Act, 1956 prescribes civil and criminal liability for directors, it does not make any distinction for independent directors and even such directors can be held to be “officers in default” under Section 5.  The institution of independent directors is the creation of regulatory requirements that are laid down by SEBI only.  “Cases like Satyam and certain others, wherein the independent directors are facing criminal liability for acts of misfeasance by the board have raised considerable disquiet and nervousness in the independent directors’ community” [7] .

Past cases, be it cheque bouncing or relating to default in the product of a particular company, reveal that directors of the companies have been unnecessarily prosecuted along with the company.

Though there has been catena of judgments magisterial, other courts have time and again summoned the directors and liability is imputed on them merely on the ground of being an office holder in the company. One such case was Srikanta Dutta Narasimharaja Wodiyar v. Enforcement Officer, Mysore [8] where offences were committed by companies under Ss. 2, 14, 14 (1A) and 14A of Employees’ State Provident Funds and Miscellaneous Provisions Act, 1952. The question was whether the Director of the company was liable for failure of company to contribute under Employees’ State Provident Funds and Miscellaneous Provisions Act. In this case, the appellant Director of company was not managing the affairs nor in charge of conduct of business. Further, the Act was a welfare legislation to provide benefit to employees as per scheme and needed mandatory implementation and violation of the same attracted strict penal action. The Court held that as per Section 14A and declaration in Form 5-A, directors or managing agents of company will be held responsible for ensuring proper management of affairs of company.

There have been a plethora of cases where the Supreme Court of India and the various High Courts have laid down a certain criteria before imputing the liability on the directors of the company. Since no specific provision has been provided for the liability of Independent Directors they are included under the term directors itself hence same liabilities are attracted as in the case of directors. Some of them have been cited below so as to enable us to draw an inference with regard to the aforementioned issue.

In M/s Pepsi Foods Ltd. v. Special Judicial Magistrate [9] the Supreme Court upheld that the responsibility lies on the shoulders of the magistrate that he must apply his mind on the facts and the averments made against the directors or the officers of the company and then summon the concerned officers or directors of the company since summoning in a criminal matter is a serious matter and a criminal matter cannot be set into motion as a matter of course.

In UP Pollution Control Board v. M/s Mohan Meaking Ltd. and others [10] the court took a slightly different stand while ascertaining the liability of directors of companies. In this case an offence was committed by the company under the Water (Prevention and Control of Pollution) Act, 1974. Under this, every person who was in charge of and responsible for conduct of business of company was also made guilty of offences by statutory creation. The Court held that the Chairman or other officers of company who consented to or connived in the commission of offence shall be liable for punishment of offence and the Trial Court was directed to proceed with case in accordance with law.

SMS Pharmaceuticals v. Neeta Bhalla [11] case is by far the most comprehensive case on director’s liability. It summarizes the law on the issue of director’s liability and the defences available to directors. This case essentially dealt with Ss. 138 and 141 of the Negotiable Instruments Act, 1881. The Supreme Court looked into the question of criminal liability on account of dishonor of cheque which primarily fell on the drawer company. The court held that “It is necessary to specifically aver in complaint under Section 141 that at the time offence was committed, the person accused was in charge of and responsible for conduct of business of company. This is the essential requirement of Section 141 and has to be made in complaint and without the said averment, the complaint requirements of Section 141 cannot be said to be satisfied. The fact that a person is a director of company is not sufficient to make a person liable under Section 141. The director of the company cannot be deemed to be in charge of and responsible to company for conduct of its business. The basic requirement of Section 141 is that person sought to be made liable should be in charge of and responsible for conduct of business of company at relevant time no deemed liability of director in such cases. The Managing director or Joint Managing director admittedly in charge of company are responsible to company for conduct of its business. The holders of such positions in the company become liable under Section 141. The Managing Director or Joint Managing Director, by virtue of the office they hold is included under Section 141. Also, the signatory of cheque which is dishonored is concerned is clearly responsible for incriminating act and will be covered under Sub-section (2) of Section 141″.

The Mumbai High Court in Homi Phiroz Ranina & Ors. V. State of Maharashtra [12] stated that “there has to be a prima facie case against the directors or officers of the company and it is the responsibility of the complainant that the allegation against the officer or directors must be specifically pleaded and also set out that the concerned accused (officer of the company) was in-charge of day to day and conduct to the business of the company.” The new Companies Amendment Bill 2009 provides for the protection of the Independent Directors from civil and criminal liability if they are not involved in the day to day business of the company.

In K.K.Ahuja Vs.V.K.Vora & Anr [13] the Supreme Court observed that “the liability arises from being in charge of and responsibility for the conduct of business of the company at the relevant time when the offence was committed and not on the basis of merely holding designation or office in a company”.

In Keki Hormusji Gharda and Ors. V. Mehervan Rustom Irani & Anr [14] the Supreme Court following the Pepsi Food Ltd. judgment held that in order to impute liability on the officers of the company only on the basis of legal fiction, specific averments in the complaint must be made and the officer cannot be held liable only on the ground that he is holder of the office in the company.

In Pepsico India Holdings Pvt. Ltd. V. Food Inspector and Another [15] , which involved the question as to what is the criminal liability of the Directors of a company which is said to have committed defaults within the meaning of Section 17 of the Prevention of Food Adulteration Act, 1954 , the Court referring to S.M.S. Pharmaceuticals Ltd.’s case held that “it is well established that in a complaint against a Company and its Directors, the Complainant has to indicate in the complaint itself as to whether the Directors concerned were either in charge of or responsible to the Company for its day-to-day management, or whether they were responsible to the Company for the conduct of its business. A mere bald statement that a person was a Director of the Company against which certain allegations had been made is not sufficient to make such Director liable in the absence of any specific allegations regarding his role in the management of the Company. Thus the appeal was allowed and the High Court judgment was set aside.

Some other cases which re-iterate the same point are:

Girdhari Lal Gupta v. Assistant Collector of Customs [16]

Kailashpati Kedia v. State of Maharashtra [17] .

TP Singh Kalra v. Star Wire India Limited [18] .

In Companies Act 1956, on careful analysis, it can be observed that IDs are included in the definition of “Officer in default” under section 5. On referring to section 292A on audit committees, the IDs are highly liable for both financial and criminal penalties, as being “officer in default” for any misdeed.  However, the accused ID can be granted relief by court, if they can satisfactorily prove that they have performed their functions honestly and exercised it with due diligence, care and caution. In most of cases, however, the director has to face the trial and has to prove in front of court that he has performed his care and diligence and he is not involved in the given accusation. The relief to prosecution is not automatically granted to ID under the present framework. The listed cases cast light on the discussed issue:

1) Supreme Court: N.K. Wahi v. Sekhar Singh and others [19]

2) Rajasthan High Court: Alim Ahuja v. Registrar of Companies [20]

3) Supreme Court: SMS Pharmaceuticals Limited v. Neeta Bhalla [21]

From the above cited cases it can be inferred that a non-executive director cannot be held liable unless his role in the commission of the offence is brought forth. The same also applies to independent directors, though it is conceded that there seems to be some confusion as regards liability of independent directors. The only defence available to directors are that the contravention had taken place without his knowledge or consent and also that he had acted with due diligence.

Companies Bill 2009 and duties and responsibilities of IDs:

The need for revamping the Companies Act, 1956 through the Companies Bill was felt in the light of the changes in the economic scenario both domestically and internationally in the past couple of decades. The tone of the Bill was to bring about such changes that would be in consonance with the national and international economic changes and to remove the redundant provisions making the act more compact, easing out the procedural requirements and regrouping the scattered provisions; yet remaining stringent on grounds of good corporate governance and protection of the interest of the investors and public at large.

The definition of Independent Directors is quite similar to the definition provided for in Clause 49 of the Listing Agreement. However there are some noticeable changes which are as follows:

The definition requires that Boards ascertain that Independent directors should possess integrity and experience.

It requires that independent directors (or their relatives) not do business with the company which amounts to more than 10% of the turnover of the company in the past two years. Similarly , Clause d of the Clause 49 definition limits the relation to any material association whereas the proposed definition in the Companies Bill limits it to ten percent. [22]

A noticeable difference in clause 6 of section 132 [23] of the companies Bill is to bar any remuneration other than sitting fee, reimbursement of expenses for participation in the Board and other meetings and profit-related commission, stock options which may be approved by the members.

Clause 147 (1 to 6) of the Bill lays down duties of a director (including ID). According to provisions of 147 (3), an ID should exercise his duties with due and reasonable care, skill and diligence. Clause 158, which corresponds to some provisions of the 292A of present Act, requires ID should form the majority and chair the audit and remuneration committee. The Chairman of stakeholders committee should also be non-executive director. In the light of this, the responsibilities of the IDs have enormously increased; he is also liable for financial penalties in failing to do so. Under provisions of the Bill, if a person who has given his consent to become the ID cannot relinquish from his responsibilities. [24]

Further, if we look at definition of “officer in default” provided in the clause 2 (zzi) of the Bill corresponding to the section 5 of the Companies Act, the IDs are included in it that is by virtue of provisions of same clause: “(vi) every director, in respect of a contravention of any of the provisions of this Act, who is aware of such contravention by virtue of the receipt by him of any proceedings of the board or participation in such proceedings without objecting to the same, or where such contravention had taken place with his consent or connivance”. They are subject to be liable for criminal and financial penalties according to clause 120 (7) of the Bill. [25]

The Companies Bill was scrutinized by the Standing Committee chaired by Yashwant Sinha which made some recommendations pertaining to responsibilities of Independent directors.

Appointment:

The committee recommended the reduction of the stipulation that proposed Independent Director could not have pecuniary relation or transactions with the company exceeding ten percent of its turnover to five percent. However, the Ministry in turn recommended its reduction to 2 percent. It was also recommended that the Ministry of Corporate Affairs was to maintain a database or panel out of which the companies were to choose their Independent Directors. [26]

Tenure:

The committee also suggested that the association of an ID with a company be reduced from the current nine years to six years.  It is reasonable to expect that an ID’s capacity to act independently would wear thin if his association with a company continues uninterrupted. [27]

Finally, the committee also recommended that a separate code for independent directors be formulated as “the institution of Independent Directors is a critical instrument for ensuring good corporate governance” and “It is expected that the system of independent directors will evolve as a corporate governance institution over time”. [28]

Upon critical examination, while proficiency and participation in management affairs may be an added advantage, the primary role of independent directors should be confined to exercising oversight from the fulcrum of public shareholders’ interest. Also, while independent directors have fiduciary duties and the same set of information rights as other directors, their liability in case of management affairs and omissions should be delineated.  Independent directors should not be expected to conduct themselves as investigative agencies and unless proven guilty of willful default, negligenc