Corporate Governance, an almost outlandish subject till a few decades ago, has become the most important part of the corporate realm today. In fact, it is believed that there exists a strong relationship between the Corporate Governance and Financial Performance of an entity. The board and the management of any company are expected to act as trustees in order to ensure the safety of capital along with a rate of return that is higher than the cost of capital. However, the corporate world has witnessed umpteen crises of confidence and credibility as a corollary of the vicious scandals, frauds, and epic failures of many large corporations recently. Towards these activities, the increased presence of Independent Directors in the boardroom has been gauged as an effective deterrent, emerging as a cornerstone of corporate governance. The roles played by the Independent Directors as a part of the board may be characterized in two ways i.e. serving as a ‘watch dog’ for the public shareholders, and serving as a strategic advisor to the controlling shareholder. Thus, being an indispensable part of the board, they are not only responsible for guiding the board but also to ensure the interests of various stakeholders. However, the manner in which the existing laws on this subject are modelled and implemented has created significant problems for professionally operating directors including non-executive and Independent Directors eventually leading to undesirable outcomes.[i]The following parts of this article will thoroughly detail the recent proposal of the SEBI followed by a detailed discussion of the issues prevailing in the extant regulatory framework marred by the inadequacies, and recommend a way forward.
A Sneak Preview into the SEBI Proposal of 2021
Recently, after a careful assessment of the extant regulatory framework, the securities market regulator, Securities and Exchange Board of India (“SEBI”) proposed sweeping changes in the regulations that deal with removal, appointment, and remuneration of Independent Directors. Further, key suggestions were also advanced with regards to the role of Independent Directors in the listed entity’s audit committee.
The existing framework (The Companies Act, 2013) provides that the Independent Directors be appointed or reappointed by the board of the entity subject to approval by shareholders. However, as noted by the SEBI Report of 2017, a majority of Indian listed entities continue to be promoter-driven, with significant shareholding held by promoter or promoter group. In such scenarios, the shareholder vote outcome is often swayed by the majority. As a matter of fact, the promoters would be in a position to influence the appointment of the Independent Directors by virtue of shareholding which would, in turn, hamper the true independence of these directors. Thus, in light of the foregoing, it becomes crucial to protect the interests of the minority shareholders, monitor managerial efficiency, and create an atmosphere of transparency coupled with accountability.
In fact, to remedy this, the new SEBI proposal which is a part of its consultation paper points towards a dual approval process for appointment, re-appointment, and removal of the Independent Directors. This measure would ensure that not only the approval of shareholders is required but also that of the majority of minority shareholders. With an analogous aim, a similar dual-structure has been followed by other countries such as the United Kingdom for premium listed companies. The practice across different jurisdictions aptly hints that the presence of Independent Director is an answer to ensuring good corporate governance.
Further, with regards to the resignation of Independent Directors, a one-year mandatory cooling-off period has been proposed. Independent Directors often resign citing superficial reasons such as pre-occupation, personal reasons, or other commitments to join the board of other companies. Noting this as a serious impediment, the SEBI proposal highlighted instances where Independent Directors, after their resignation, joined the same entity again for a larger role. Apart from such conduct being grossly unethical, it compromises the true independence of the role of these directors. It has also been recommended that the complete resignation letter of such Independent Directors be unveiled to shareholders to ensure absolute transparency. Furthermore, the process of remunerating through the way of an Employee Stock Ownership Plan (ESOP) is a positive development as it would make the Independent Directors interested in the long-term performance of the company. Owing to the long vesting period of 5 years, this step would not only address the concerns of short-termism but also eliminate potential conflicts that may arise because of the existing profit-linked commission. Earlier, the profit-related commissions given to them made them a stakeholder in the company’s short-term performance.
Additionally, the new proposal also hints towards tightening the selection process of Independent Directors by the Nomination and Remuneration Committee (“NRC”) by bringing in more transparency. Towards this end, it has been proposed that the services of external agencies be used to shortlist candidates suitable for the position of Independent Directors, and a rigorous analysis based on the skill set of the individuals is conducted. Further, apart from modifying the composition of NRC from majority of IDs to include 2/3rd IDs, it has also been suggested that channels used for finding a suitable candidate be disclosed.
Challenges faced by the institution of Independent Directors
Although the SEBI proposal plugs in certain loopholes to strengthen the roles of independent directors, it fails to address the fundamental issues that affect the liability framework of independent directors. At present, the liability framework governing independent directors entrusts them with disproportional liability risks and duties. Some laws, for instance: Foreign Exchange Management Act, 1999 and Negotiable Instruments Act, 1881, impose vicarious criminal liability upon them without making out any difference between executives and non-executives, which leads to significant risks attached to their roles without giving them enough power.
While the current proposal seeks to ensure the ‘independence’ of independent directors, little attention has been paid to how they can effectively carry out the monitoring role. Independent directors often rely upon the information which the management decides to present to them.[ii] Further, their role is often compromised by a lack of time, domain knowledge, and resources needed to comprehend the complex information and data of the company.[iii]
Another shortcoming that is attached to this institution is the fear of loss of reputation and loss when any independent director is impleaded in any legal proceeding instituted against the company. In case any legal proceeding is instituted against the company or its management, independent directors are subjected to significant embarrassment and inconvenience even if they do not have any involvement in the day-to-day functioning of the company. Mention must be made of the instances where even the directors are summoned as accused when their names are not there in any charge sheets or First Information Report.
Though statutory protection is provided to the independent directors through Section 149(12) of the Companies Act, 2013, limitations imbibed in this section had to lead to some undesirable court decisions like the Somendra Khosla case. Under the aforementioned section, independent directors can be implicated for any passive negligence committed in their tenure. The subjectivity of passive negligence can implicate them for any corporate action where the decision has been taken without their full knowledge and consent. Moreover, the immunity provided under Section 149(12) of the Companies Act, 2013 is restricted to the offences mentioned under the Companies Act. Owing to these limitations, independent directors resign from their institution without giving any adequate reasons. It is pertinent to mention that many independent directors have resigned in the last few years providing superficial reasons such as pre-occupation, personal, or health reasons (Total resignations: 1393 in the year 2019, 767 in the year 2018, 717 in the year 2017).
Section 197 (13) of the Companies Act, 2013 mentions the insurance obtained by the company for the managing director, chief executing officer, chief financial officer, and whole-time director. However, no such insurance is provided to the independent directors for indemnifying them against “any liability in respect of any negligence, default, misfeasance, breach of duty or breach of trust”. Though LODR regulations provide for the mandatory requirement of insurance for independent directors, they become applicable only for the top 500 listed entities in terms of market capitalization. Thus, there is no express provision in any statute that makes it mandatory for all the companies to have insurance for the independent directors.
Conclusion: Tightening Governance
The importance of good leadership and monitoring is paramount at the time when companies navigate through these tumultuous times owing to the Covid-19 pandemic. The SEBI has tried to strengthen the role of Independent Directors by mitigating some influence of the majority shareholders in their appointment procedure. However, a lot of issues faced by the existing liability framework of Independent Directors are not addressed by the SEBI proposal. There still exists a need to re-assess the existing framework to ensure better standards of corporate governance in the country. The safe harbor provisions like Section 149(12) of the Companies Act, 2013 should be made applicable to all other statutes penalizing corporate offences so that adequate protections are provided for the Independent Directors to avoid unnecessary embarrassment and inconvenience. The investigating procedure should also be regulated in such a manner that independent directors are not being summoned until a prima facie case is built against them. Moreover, it is pertinent to deal with the overarching issue of disproportional duties and responsibilities attached to them with limited powers. The inadequacy of this institution would not go away until they are given some real powers to play an effective role in protecting the interests of every stakeholder. Therefore, it is imperative to ensure all these recommendations are implemented so that the robust institution of Independent Directors can effectively form the backbone of corporate governance in India.
[i] D. Mukherjee & A. Pandey, The Liability Regime for Non-Executive and Independent Directors in India- A Case for Reform, Vidhi Centre for Legal Policy (2019).
[ii] K. Kastiel and A. Nili, “Captured Boards”: The Rise of “Superior Directors” and the Case for a Board Suite, Harvard Law School Forum on Corporate Governance and Financial Regulation (2017).
This article has been authored by Gauransh Gaur, and Aniket A. Panchal, students at Gujarat National Law University, Gandhinagar. This article is part of RSRR’s Corporate Governance Blog Series.