An independent board of directors and corporate governance are two sides to the same coin. The Board should be capable of assessing the performance of managers with an objective perspective. Therefore, the majority of Board members should be independent of both the management team and any commercial dealings with the company. Good corporate governance is essential to
- steward the company,
- sets its strategic aim and financial goals and oversees their implementation,
- puts in place adequate internal controls, and
- periodically reports the activities and progress of the company in a transparent manner to all the stakeholders.
In India, the concept of an independent director was introduced in the year 2000 by SEBI. A new Clause 49 was added to the Listing Agreement inter alia prescribing the composition of the Board and the tests for regarding a director as independent.
The recent Companies Bill, 2012, passed by Lok Sabha in December 2012, contains elaborate corporate governance provisions. An independent director is defined under the Bill as a director other than a managing director or a whole-time director or a nominee director.
Appointment of Independent Directors
The Bill provides for the manner of selection of independent directors from a data bank maintained by anybody, institute or association notified by the Central Government. The databank shall contain names, addresses and qualifications of persons who are eligible and willing to act as independent directors. Responsibility of exercising due diligence before selecting a person from the data bank shall lie with the company making such appointment.
The appointment of independent director has to be approved by the company in a general meeting and the explanatory statement annexed to the notice of the general meeting should indicate the justification for choosing the person for appointment as independent director.
The code of conduct prescribed under the Bill, provides that the independent director is required to be mandatorily appointed by way of an appointment letter or agreement. The Code prescribes that the letter of appointment shall set out:
- the term of appointment;
- the expectation of the Board from the appointed director; the Board-level committee(s) in which the director is expected to serve and its tasks;
- the fiduciary duties that come with such an appointment along with accompanying liabilities;
- provision for Directors and Officers (D and O) insurance, if any;
- the Code of Business Ethics that the company expects its directors and employees to follow;
- the list of actions that a director should not do while functioning as such in the company; and
- the remuneration, mentioning periodic fees, reimbursement of expenses for participation in the Boards and other meetings and profit related commission, if any. Under the Bill, independent directors shall not be entitled to any stock option.
Disclosure Requirements: The terms and conditions of appointment of independent directors shall be open for inspection at the registered office of the company by any member during normal business hours. The terms and conditions of appointment of independent directors shall also be posted on the company’s website.
Qualification of an Independent Director
In order for a person to qualify as an independent director, he shall have no association with the company, pecuniary or otherwise. The Bill extends this principle of non-association to the relatives of the directors as well. The Bill also prescribes limits for directors who are independent professionals or form part of a professional organization such as an auditing firm or law firm. Many companies would like to have on their Boards lawyers and auditors to give their Boards the experience and specific expertise the business may require. This will now be rendered very difficult. For law firms however, only those firms are excluded that have had any transaction with the company, its holding, subsidiary or associate company amounting to 10% or more of the gross turnover of such firm.
The Bill retains the rights for prescribing further qualifications, if required.
Declaration: Every independent director is required to give a declaration that he fulfills the criteria of independence provided for in the law, at the first Board meeting in which he participates as a director and thereafter at first Board meeting of every financial year or whenever there is any change in the circumstances that may affect his independence. The onus for ensuring that the appointment of an independent director is fully compliant with the Bill is imposed on the directors themselves.
Cool – off period for reappointments: The initial term of office of an independent director is 5 years. He is eligible for reappointment on passing of a special resolution by the company and disclosure of such appointment in the Board’s report. Further the Code provides that the re-appointment of independent director shall be on the basis of report of performance evaluation.
No independent director can hold office for more than two consecutive five-year terms in one company. A cool off period of three years has been prescribed. During the cool off period, he shall not be appointed in or be associated with the company in any other capacity, either directly or indirectly.
Replacement Independent Director: An independent director who resigns or is removed from the Board of the company shall be replaced by a new independent director within a period of 180 days from the date of such resignation or removal, as the case may be. This does not however apply to a company that is fully compliant with the requirement of independent directors in its Board even without filling the vacancy created.
Limitation of liability – Independent directors are liable only for such acts of omission or commission by a company that had occurred with his knowledge, attributable through board processes, and with his consent or connivance or where he had not acted diligently.
Code of Conduct: Schedule IV of the Bill prescribes the Code to which the director as well as the company shall adhere. The Code inter alia provides guidelines of professional conduct, elaborates the role and functions of an independent director and lays out his fiduciary duties.
Separate meetings: Independent directors of the company are required to hold at least one meeting in a year, without non-independent directors and members of management attending it. The lead independent director shall conduct such meeting. This meeting shall be held for the following purposes:
- review the performance of non-independent directors and the Board as a whole;
- review the performance of the Chairperson of the company, taking into account the views of executive directors and non-executive directors;
- assess the quality, quantity and timeliness of flow of information between the company management and the Board that is necessary for the Board to effectively and reasonably perform their duties.
Challenges for a Listed Company
The good news is that companies have a period of one year from the commencement of the new Companies Act or from the date of notification of the relevant rules to ensure compliance with some of the corporate governance provisions. However, the Board of all listed companies should be exceedingly careful in making future appointments of independent directors. While it may be a while before the database is created of potential appointees, companies should re-look at their existing Board composition today and start to formalize the appointments with independent directors.
Independence of directors is tested vis-à-vis the relationship of the director with “associate companies”. Associate companies is so widely defined, appointment of an independent director may become a nightmare for corporates that have complex group structures. Companies should relook at appointments with a view to identifying associations of directors with their associate companies (as well as holding and subsidiary companies).
Additionally, companies would have to comply with the mandatory norms of disclosures in relation to the terms of appointment of independent directors.
The lenders and other financial institutions would not be very pleased about a nominee director being excluded from the definition of independent director. Additionally, for companies where the compliance of Clause 49 of the Listing Agreement has been made possible on account of the presence of such nominee directors, a hunt for independent directors to reconstitute their Board is impending.
In light of the recent happenings, companies will have to expend substantial time and resources to get a candidate who is independent as per the Bill and will continue to remain independent going forward.