AbstractIndependent Directors of a company have a very important role in assuring quality corporategovernance in a company. The landmark legislation regarding independent directors is theClause 49 of the listing agreement of the SEBI Guidelines given out in the year 2005. However following various scams that took place in India and in other countries like the SatyamScam and The Enron Scam due to which the role of Independent Directors have come underthe spotlight once again. The following paper is about the role of Independent Directors in acompany.
IntroductionThere have been en masse resignation of Independent Directors in various companies thatunderwent various corporate governance scams, it has brought the role of independentdirectors in the corporate governance of the company under heavy scrutiny. The Satyamscam is not the only incident wherein the independent directors showed lack of responsibilitytowards the duties that they are expected to perform, the spate of highly publicized corporategovernance scandals such as Enron, WorldCom and including the Walt Disney Company,Hollinger International and Airbus Industries, have resulted in putting corporate governanceunder heavy scrutiny in the public spotlight.The concept of independent directors is not new, it has evolved over the past 20 years, sincethe concept and position were first introduced. Independent directors are expected to play anextremely crucial role in ensuring the high quality of corporate governance in a company.
Itis their burden to provide an assurance to all stakeholders of the company that all the dealingsof the company will be undertaken in a responsible manner.In the landmark case on the point of Independent Directors would be, Lennard's CarryingCompany Ltd v. Asiatic Petroleum Co. Ltd ,Viscount Haldane, Lord Chancellor, whilehighlighting the importance of non executive directors, had elaborated and specified how thenon executive directors' contribution can be instrumental in complementing the executive'scompetence by stating :"My Lords, a corporation is an abstraction.
It has no mind of its own any more than it had abody of its own; its active and directing will must consequently be sought in the person ofsomebody who for some purposes may be called an agent, but who is really the directingmind and will of the corporation, the very ego and centre of the personality of thecorporation. That person may be under the direction of the shareholders in general meeting;that person may be the board of directors itself, or it may be, and in some companies it is so,that that person has an authority to co-ordinate with the board of directors given to him underthe articles of association, and is appointed by the general meeting of the company, and canonly be removed by the general meeting of the company."Further the Naresh Chandra Committee while emphasising on the significance of thepresence of Independent Directors in the composition of the Board of a company had statedthat, “Clearly, a board packed with executive directors, or friends of the promoter or of theCEO, can hardly be expected to exercise independent oversight judgement.”Independent Directors constitute a necessary component of a balanced board structure wherethe in depth knowledge of the executive directors is blended with the wider experience andknowledge of the independent outside directors. Independent directors in particular canprovide a perspective to the discussion based on their experience, technical expertise andwisdom that make a great contribution in the area of strategy. In the following article, we will be critically examining the concept of Independent Directors,the role they play in the corporate governance of the company and their under liability for thecompanies actions.AnalysisThe concept of “independent directors” is not an inherent one in the Indian businessorganisation system but has been borrowed from the corporate governance norms of the U.
S.and U.K.The term "independent Directors" became a part of the Indian corporate lexicon after thepublication of the Kumar Mangalam Birla committee report, formulated by SEBI, to start upreforms in the area of Corporate governance, which resulted in the introduction of clause 49in Listing agreements. The committee had extensively debated on the issue of independentdirectors and opined that independence be suitably, correctly and pragmatically defined, sothat the definition itself does not become a constraint in the choice of independent directorson the board of companies.
The Birla committee defined Independent Directors as those”who apart from receiving directors remunerations do not have any other material pecuniaryrelationship or transactions with the company, its promoters, its management or itssubsidiaries, which in the judgement of the board may affect their independence ofjudgements.”On 21st August 2002, following the enactment of the Sarbanes–Oxley Act of 2002 in theU.S., the Ministry of Finance appointed the Naresh Chandra Committee to examine variouscorporate governance issues primarily around auditor – company relationship, rotation ofauditors and defining Independent directors. The committee came to the conclusion that thedefinition in contained in clause 49 of the Listing Agreement could be made more precisewithout compromising the spirit of the independent directors. It recommended thatindependent directors should not be less than fifty percent of the board and that nomineedirectors of lending institutions not be considered as independent. It also provided fortraining of independent directors and recommended to exempt them from criminal and civilliabilities.
In 2003, SEBI constituted the Narayana Murthy committee, with the aim to review Clause 49of the Listing Agreement, and suggest measures to improve corporate governance standards.The committee adopted the Chandra Committee definition of independent directors, however,without the condition of nine-year term.It is on the basis of the above recommendations that the definition independent director hasbeen formulated under the Indian law.
As per clause 49 of the Listing Agreement an’independent director’ shall mean a non-executive director of the company who:a. apart from receiving director’s remuneration, does not have any material pecuniaryrelationships or transactions with the company, its promoters, its directors, its seniormanagement or its holding company, its subsidiaries and associates which may affectindependence of the director;b. is not related to promoters or persons occupying management positions at the board levelor at one level below the board;c. has not been an executive of the company in the immediately preceding three financialyears;d. is not a partner or an executive or was not partner or an executive during the precedingthree years, of any of the following:i) the statutory audit firm or the internal audit firm that is associated with the company, andii) the legal firms and consulting firms that have a material association with the company.e. is not a material supplier, service provider or customer or a lessor or lessee of thecompany, which may affect independence of the director; and,f. is not a substantial shareholder of the company i.
e. owning two percent or more of theblock of voting shares.Although the Indian Companies Act, 1956, imposes a legal duty on all directors to act in thebest interests of the company it has been observed time and again, that the same is notadequate to give full assurance, that, potential conflicts between the interests of the majoritystakeholders and those of the public, will not impair the board’s decision-making, particularlywhen family-run businesses account for such a large proportion of Indian companies. It is insuch circumstances that the need for Independent Directors arises.Independent Directors counterbalance management weaknesses in a company and also ensurethat the company follows a legal and ethical framework in there day to day transactions,while strengthening accounting controls.More importantly, the need for appointing independent directors on the board of a companyarises due to the fact that they are the sole representatives of the public shareholders and thushave the responsibility of upholding their interests in the company. In fact the main rationalebehind appointing Independent Directors in the company’s board is to keep a check on theactivities of the company, as an oversight mechanism.
.The Naresh Chandra Committee while expressing its views on the role of IndependentDirectors had stated that, “at the core of corporate governance is the board of directors.”Furthermore, the Supreme Court in Central Government Vs.
Sterling Holiday Resorts (India)Ltd. and Ors. had also emphasised that the “the Board of directors should be strengthened byappointing independent directors.
” The role of Independent Directors ranges from policies regarding the long-term survival ofthe company to improved internal controls.Managerial oversight is an important function of a board of directors. Independent membersbring in an objective view while evaluating the board and managements decisions since theyhave no personal interests in the company. Independence is particularly crucial in those areaswhich involve a potential conflict of interest between managers and shareholders.
Independent directors have a crucial role to play, especially since the majority of companiesin India are family-run businesses, having a strong control over their management. In suchcases, the presence of a good ratio of Independent Directors on the board helps in reducinginstances of conflict between the majority and minority shareholders interests and ensuresthat the rights of minority shareholders are upheld and protected.Independent Directors bring wider experience, expertise and a fresh perspective to theboardroom and can effectively exercise their best judgment for the exclusive benefit of theCompany, since their judgment is not clouded by real or perceived conflicts of interest.As public information has become more transparent and reliable, investors—especiallyinstitutional investors now clearly prefer companies with better governance standards, overthose whose corporate governance practices may still be dubious.
Having independentdirectors on boards sends a very strong signal to investors that the company is well run andgoverned, and its board is sound enough to ensure that nothing less than the very bestinternational corporate governance practices are adhered to.The presence of independent directors brings diversity to the board. While executive directorsbring with them the organizational insight, independent directors, on the other hand,generally being experts in their respective field, get their knowledge, expertise and objectivemindedness to the table. Together, a balanced board can steer the company on the path ofsuccess.
The process of the internal control commences right from the development of new policies bythe Board of directors and includes administrative regulations, manuals, directives anddecision, internal auditing etc. The independent directors act as a supervisory bodymonitoring the internal control system of the company and are responsible for theidentification of flaws in the internal control system and presenting them before the board tofind suitable solutions. Independent Directors are responsible for identifying and analyzing all such risks that mayLennard's Carrying Company Ltd v. Asiatic Petroleum Co. Ltd ,Viscount Haldane threatenthe assets, resources and earning capacity of the company. Their role is to critically scrutinizethe decision making process and ensure that the investments, funds, business transactions etcdo not result in losses. By virtue of their appointment and the subsequent role played by them in managing theaffairs of the company, the liability of independent directors has been a matter of debate andcontroversy.
A lesser degree of liability for independent directors has been advocated by some quarters,citing differences in their roles in comparison with those of the executive directors. While expressing its views on the subject, the Naresh Chandra committee had opined that noteven the most stringent international tenet of corporate governance and oversight assumesthat an independent directors who interacts with the management for no more than two daysevery quarter will know of every technical infringement committed by the management of thecompany in its normal course of activity.The committee had further observed that at a more practical level, it would be very difficultto attract high quality independent directors on the board of Indian companies if they have toconstantly worry about serious criminal liabilities under different acts.
This view was reiterated by the Irani committee who had recommended that the independentdirector should not be held liable for contravention of any provisions of law that happenswithout his knowledge or consent or connivance. The new Companies Amendment Bill 2009, contains a similar provision which is based onthe Supreme Court’s verdict in the case of KK Ahuja v VK Arora where the court had heldthat “liability arises from being in charge of and responsibility for the conduct of business ofthe company at the relevant time when the offence was committed and not because on thebasis of merely holding designation or office in a company." Further in S.K Alagh Vs Stateof U.P &Ors, the Supreme Court had held that “Indian Penal Code, save and except someprovisions specifically providing therefore, does not contemplate any vicarious liability onthe part of a party who is not charged directly for commission of an offence.”Thus there is a general consensus among the people that the responsibility of independentdirectors is ideally considered to end with vigilance in the Board meetings and that theycannot be held liable for acts outside their knowledge.However, the 2010 judgement of the Bhopal District Court, sentencing Mr Keshub Mahindra,a former non-executive director of Union Carbide, with two years of imprisonment, in theBhopal Gas tragedy case, has given rise to a series of arguments regarding the scope ofindependent director’s liability.
Those supporting the court’s decision are of the view that the ultimate legal responsibility fora company’s act lies with its board of directors and when a crime takes place, it is theircollective responsibility to be liable and since neither the Companies Act, nor any otherlegislation excludes Independent Directors from criminal liability, they are also equallyaccountable for such acts. Colin Gonsalves, founder of the New Delhi-based Human RightsLaw Network, is of the view that, “being an independent director does not mean beingindependent of law.” According to him ‘sleeping’, ‘non-executive’ and ‘independent’ are justpretentious terms to restrict the legal responsibility of a director in the company and that,”there are no restrictions in the law to cut down liability.” On the other hand, many believe that even though, as board members, independent directorshave the same legal duties and obligations as executive directors, but, because of their limitedinvolvement in the day-to- day running of the company, it is undesirable for the law to exposethem to personal liability. The CII has strongly recommended that the law regarding thepotential liability of independent directors needs to undergo a change, for independentmembers cannot be made to undergo the ordeal of a trial for offence of non-compliance witha statutory provision unless a prima facie case has been established against them holdingthem liable for the failure on part of the company.
In the absence of such safeguards, many believe that, people will be far more reluctant andcareful in accepting the position of independent directors in this atmosphere of uncertainty. CONCLUSIONWhile independent directors form an essential and powerful component of a company,providing numerous advantages to the board, however in order to ensure that they areactually able to play an effective role in the corporate governance of the company, there is anurgent need to strengthen the institution of independent directors. Efforts should be made toproperly lay down and codify laws regarding their responsibilities, duties and rights. Further,in order secure the independence of independent director there is need to break the nexusbetween the independent directors and promoters who sponsor them. The nomination ofindependent director by SEBI and government can be a suitable solution for the same. Thusit can be clearly concluded that independent directors have the potential of becomingeffective regulators of the company’s activities and policies provided sufficient and adequateprovisions are made for their empowerment.