Introduction
The Supreme Court recently put an end to a four-year-long corporate battle between the Tata Sons and Cyrus Mistry in Tata Consultancy Services Ltd. v. Cyrus Investments Pvt. Ltd. And Ors.) by pronouncing judgment in favour of Tata Sons (Facts of the case are available here).
However, the Supreme Court in this judgment has made an observation that undermines an important aspect of corporate governance i.e., Independent Directors (“IDs”). The judges questioned the rationale of having at least 1/3rd IDs in public listed company u/s 149 if, Section 166 of the Companies Act, 2013 (“CA, 2013”) mandates every director of a company to exercise independent judgment. In this post, the author provides reasoning as to why this observation is erred.
The author contends that firstly, the court has narrowly interpreted the term “independent judgment”, secondly, the court has disregarded the concept of IDs and thirdly the observation is contrary to the intention of legislation behind Section 149(6).
It is pertinent to mention that the duties mentioned u/s 166 apply to all directors (independent and non-independent directors). There is no specific exclusion of any type of director.
The Narrow Interpretation of the Duty of Independent Judgment
Independent judgment has not been defined in CA, 2013. Reliance will be made on United Kingdom Companies Act, 2006 (“CA, 2006”) since Indian company legislation has closely followed the UK Corporate legislation,[i] the duties of directors are almost similar in both the countries (except the provision of codifying the common law duties of directors in the UK), and in author’s opinion, the interpretation of independent judgment in the UK aligns with the objective of Section 166 of CA, 2013 which is that director has to work in the best interests of the company, shareholders and stakeholders.
The duty to exercise independent judgment bears a relationship with the duty to avoid conflicts of interest (Keymed (Medical and Industrial Equipment) Ltd v. Hillman and Anor). As per the Cambridge definition, independent means free from outside control or influence. Freedom from such influence or outside control is the most essential aspect of IDs. This is how the Supreme Court, in this case, seemed to interpret the term independent judgment and connected it with independent directors.
Even though this is not the wrong interpretation of the term, however, in the author’s opinion, it is a narrow interpretation. Independent judgment in the context of duties of directors means applying an independent mind when making decisions on behalf of the company. What makes a decision independent is not only excluding pecuniary or personal interest but also how a director applies professional advice in his decision making.
Lord Gold-Smith, in the Lords Grand Committee, Col. 282, 6th Feb 2006 explained the scope of Section 173 of the CA, 2006 (UK) [equivalent to Section 166(3) of CA, 2013]:
“Section 173 does not mandate every director to be independent himself. He can have an interest in transactions. It is the judgment that must be from his own independent thinking. Section 173 does not prevent a director from relying on the advice of professionals, but the final judgment or decision must be his responsibility.”[ii]
Section 166 (3) of CA, 2013 or its equivalent Section 173 of CA, 2006 (UK) prevents directors from blindly relying on any advice even given by a professional.
Further, in 2018, the British Government published a consultation paper on Insolvency and Corporate governance where the duty of the director to exercise independent judgment was discussed in terms of the directors using professional advice for making decisions.
As stated earlier, in the author’s opinion, the interpretation in the UK regarding “independent judgment” is in consonance with Section 166 of CA, 2013. The ability to exercise independent judgment is indispensable for every director and not only IDs because it assists a director to make decisions that are fair, reasonable and commercially beneficial to the company. This conduct is also in consonance with the judgment of Miheer H Mafatlal v. Mafatlal Industries wherein the court stated that directors should make such decisions that are just and commercially beneficial to the company. Therefore, the term has been interpreted narrowly in this case.
Disregards the Concept of Independent Directors
This observation undermines the efforts of the legislature and Securities Exchange Board of India (“SEBI”) made over the last two decades to enhance the roles, responsibilities and liabilities of IDs in India.
This is because the court has equated IDs with other non-independent directors based on the ground that Section 166(3) mandates all directors to exercise independent judgment. The court has taken no notice of the fact that independent directors are a distinct class of directors who perform a pivotal role in enhancing the corporate governance of a company.
As stated in Uday Kotak Committee on Corporate Governance report, IDs are the backbone of corporate governance worldwide because they bring objectivity to the board to firstly, balance the interest of the promoters and other stakeholders especially minority shareholders and secondly, increase the effectiveness of the board.
The law casts an onerous duty on the IDs. Compared to non-independent directors who have to follow duties u/s 166 and other duties as provided in the Articles of Association, the IDs have to follow not only Section 166 but also Schedule IV of the CA, 2013 which contains the code of professional conduct for IDs.
Duties of the IDs include taking part in decision making, keeping a check on all non-independent directors, evaluating the performance of management, ensuring better corporate disclosures and chairing various important committees such as the audit committee and in the case of listed companies, the nomination remuneration committee (NRC). NRC is an important committee as it sets the criteria for appointment of directors and senior management, recommends directors to the board and specifies the manner for effective evaluation of the performance of the Board.
They are the watchdogs who look after the interests of minority shareholders. They do this by checking the integrity of financial information, reporting concerns regarding fraud, unethical behaviour or violation of law by the management.
One instance of this is the Maruti Suzuki Gujarat Plant case 2014. In 2014, when the CA, 2013 was not in force, Maruti Suzuki India Limited (MSIL) entered into a related party transaction with Suzuki Motor Gujarat Private Limited. MSIL’s institutional investor resisted this transaction on the grounds of lack of transparency and the suspicious timing of this transaction. Based on this, the board reconsidered this decision, in which IDs played the lead role. After reconsideration, more information regarding it was disclosed to shareholders and the board also took the vote of minority shareholders which was not mandatory then. The IDs also sought more transparency on the impact of tax on the proposed arrangement for MSIL.
A study shows that the proportion of IDs on the board has a positive relationship with the financial performance of the company. An important reason for this is that IDs more effectively monitor the other directors and management of the company. Further, an evaluation of a financial statement by an independent director generates more confidence from potential investors because the scope for fraud is less.
However, it is important to note that, even though the IDs have a more onerous job, it does not mean that non-independent directors are subject to a lower standard of liability. The intention of the legislation has always been to enhance the standard of duties of directors.
Contrary to the Intention of Legislation Behind Section 149(6)
Unlike for non-independent directors, the qualifications for becoming an ID have been laid down in Section 149(6), Clause 49 of the SEBI guidelines and Regulation 16(1)(b) of SEBI (LODR) Regulations 2015. Section 149(6) sets a high standard for the selection of ID because the whole concept of ID effectively works in corporate governance if they are truly independent.
Section 149(6) is an exhaustive definition of ID as it uses the expression “means” to define them. As held in Punjab Land Development and Reclamation Corpn. Ltd. v. Presiding Officer, Labour Court, the expression “means” connotes a hard-and-fast definition and no other meaning can be assigned to it.
Equating a director to the status of the ID based on having independent judgment and without considering any other qualification is against the intent of legislature behind Section 149(6) because it disregards the exhaustive list of qualifications u/s 149(6).
Conclusion
In the author’s opinion, Section 149(4) and Section 166(3) are not contradictory or paradoxical. Section 166 states the general duties of all the directors of all kinds of companies whereas Section 149(4) applies specifically to the independent directors of public companies. The CA, 2013 makes it clear that independent directors are different from other directors in terms of appointment, role and duties in the company. If this observation becomes a precedent, it will be a backward step in corporate governance of India.
[i] G. K. Kapoor, Company Law 1 (Taxmann’s 2019).
[ii] John Lowry, The Irreducible Core of the Duty of Care, Skill and Diligence of Company Directors: “Australian Securities and Investments Commission v. Healey”, 7 Mod. Law. Rev. 249, 258 (2012).
This article has been authored by Vishesh Gupta, a student at the Institute of Law, Nirma University. This article is part of RSRR’s Corporate Governance Blog Series.