Role of Independent Directors

Introduction:

“Independent directors are nominated by the management and are at the mercy of the promoters. So, the independence of the directors is more a myth than a reality.”

In the current market driven economy, the board of directors has a pivotal role in the management of a company, as it is the centre of all management powers and authority. It provides leadership and strategic guidance, objective judgment, independent of management to the company and exercises control over the company. It is not involved in the day to day management and administration of the company which is the responsibility of the management. However, it controls the company and its management by laying down the code of conduct, overseeing the process and disclosure and communications, ensuring that there is appropriate system for financial control. The board consists of eminent people drawn from various professions and business backgrounds and exercises all the powers of a company, except those reserved for the shareholders to whom they are responsible. The Executive Directors are involved in the day to day management of the company; the non-executive directors bring external and wider perspective and independence in the decision making.

Over the last decade and a half, the Securities and Exchange Board of India (SEBI) has steadily focused on incorporating corporate governance principles into the regulatory framework applicable to Indian publicly listed companies. Corporate Governance implies a well defined, well structured and well communicated system to manage, direct and control the business of the company. The principle of corporate governance brings about a need for supervision over the activity of the management and bring about a sense of accountability so that the interest of the owners are safeguarded and that the management should observe and follow ethical standards in its dealings and should keep informed all the interested parties thereby bringing about transparency in the functioning of the company. Independent Directors plays a vital role in ensuring Corporate Governance in a company. It is said that if the board of directors consists of right mixture of executive and non-executive directors and among the non-executive directors, it comprises of independent directors who could discuss without any bias matters pertaining to company affairs, good governance would automatically follow. The rationale behind having independent directors is that it would increase the quality of board supervision and reduce the possibility of damaging conflict of interest.

The regulatory focus to codify corporate governance standards manifested itself as Clause 49 of the standard listing agreement that all listed companies were required to comply with after 31 December 2005. The institution of Independent Directors is one of the major components in this clause of the listing agreement. Independent Directors bring about an element of objectivity to Board processes in general interests of the company and thereby to the benefit of the shareholders especially the minority and small shareholders.

The recent Satyam scandal has put the role of independent directors in the spotlight. It is not only in Satyam that independent directors showed lack of commitment; earlier in the case of Enron, WorldCom and other companies in which corporate governance as well as independent directors failed to perform effectively. It is seen that after the satyam incident, the independent directors of the company and other such companies have relinquished their respective posts thereby jeopardizing the position of the independent directors in the company. The first part of the paper will analyse clause 49 of the SEBI listing agreement and the amendment to the clause which defines Independent Directors and also lays down their role in ensuring corporate governance. The second part of the paper will basically look at role which the independent director has to play especially with regards to safeguarding the interest of the shareholders. The third part of the paper will look into the independence of the independent director which is a highly debated aspect of the independent directors since its inception.

Clause 49 Of The Listing Agreements:

The concept of “independent directors” is new to India. This concept is borrowed from the US Sarbanes-Oxley Act 2002, which was passed after the various instances of major corporate failures. Consequently, in line with the recommendations of the Kumar Mangalam Birla Committee, the Naresh Chandra Committee and the Narayanan Murthy Committee, the Securities and Exchange Board of India (SEBI) revised the governance norms in Clause 49 of the Listing Agreement in order to improve the standard of corporate governance. The role and functions of independent director is the key component of the clause.

Clause 49 of the Listing Agreement was first introduced in the year 2000 on recommendations of Kumar Mangalam Birla committee. After these recommendations were in place for about two years SEBI setup a committee under the Chairmanship of Mr Narayana Murthy during 2002-03 in order to evaluate the adequacy of the existing practices and to further improve the existing practices The Murthy committee submitted their draft recommendations on corporate governance norms. After deliberations, SEBI accepted the recommendations in August 2003 and asked the Stock Exchanges to revise Clause 49 of the Listing Agreement based on Murthy committee recommendations. However, the Murthy committee had to meet again to consider the objections from the Industry. The committee, thereafter, considerably revised the earlier recommendations and the same was put up on SEBI website on 15th December 2003 for public comments. It was only on 29th October 2004 that SEBI finally announced revised Clause 49, which will have to be implemented by the end of financial year 2004-05. Non-compliance with the provisions of corporate governance in clause 49 would invite penalties such as suspension of trading and delisting from the stock exchange.

The revised clause introduces checks and balances in various forms to ensure that corporate business is carried out with transparency that would help the investors make informed decisions. SEBI has revised clause 49 of its listing agreement to stipulate that at least one-third of the directors on board of the companies should be independent professionals who are in no way connected to the interests of the promoters. As has been stated earlier, the key to corporate governance lies in transparency in decision-making and accountability to safeguard the interest of the stakeholders and the investors. This clause lays down the definition independent directors to mean those directors who apart from receiving remuneration do not have any pecuniary relationship and transaction with the company, its promoters, its management or its subsidiaries which in the judgment of the board may affect independence of the judgment of the independent directors. The main reason for the appointment of independent director is to strengthen the internal control in absence of effective shareholder control. It is said that as far as the definition of independent director is concerned, material pecuniary relationship which affects the independence of a director should be the litmus test of independence and the Board of the company would exercise sufficient degree of maturity when left to itself, to determine whether a director is independent or not.

The clause also provides that the Board of a company should have an optimum combination of executive and non-executive with at least 50 per cent of the board of a listed company should consist of non-executive directors. Furthermore, in the case there being a non executive chairman, at least one third of the board should comprise of independent directors. In case the chairman is an executive then at least one half of the board should be independent.

The clause also talks extensively about the role of the independent directors in the audit committee and lays down that it shall have at least three non executive directors. It provides that the chairman of the audit committee should be an independent director, and that he should be present at the company’s annual general meeting to answer shareholder’s queries. The key role of the audit committee would include oversight of financial reporting process and disclosure of its financial information.

Role Of Independent Director:

It is increasingly recognized that the independent directors have an important role to play in the progress of the company. They are considered as both a safeguard and a significant source of competitive advantage. Corporate Governance reformers presume that the outside independent directors are better than the non-independent boards and more independent a board is, the better is the efficiency within the company. The role they play in a company broadly includes improving corporate credibility and governance standards, functioning as watchdog, maintaining balance in a promoter dominated scenario, play vital role in risk management. Their main role in the company is to protect the interests of the minority shareholders vis-à-vis the promoters.

It is a common belief that an independent director helps in the proper functioning of the corporate because of the fact that they do not have any pecuniary interest in the company and that they will represent the interest of the shareholders. In the modern public corporation, shareholders essentially have no power to initiate corporate actions and moreover they are entitled to vote only in few corporate actions. It is mainly the board of directors that makes formal decisions. The Independent Directors therefore bring about a sense of objectivity to board processes in the general interest of the company and to the benefit of all stakeholders including minority and small share holders.

Shareholders appoint the directors to oversee the operational management so as to ensure that it functions to maximize corporate wealth. In case of conflict between the objectives of the management and the interest of the shareholders, the independent segment of the board of directors must be able to stand up and discharge its fiduciary oversight functions. The significance of the independent directors on corporate board lies in its ability to take an independent decision on a given subject without being influenced in any manner. The shareholders, especially the minority shareholders, look to independent directors providing transparency in respect of the disclosures in the working of the company as well as providing balance towards resolving conflict areas. In evaluating the board’s or management decisions in respect of employees, creditors and other suppliers of major service providers, independent directors have a significant role in protecting the stakeholders interests.

The independent directors also play a key role as a member of the audit committee of the company. The chairman of the audit committee is an independent director according to the clause. The audit committee is an operating committee of a publicly held company. The responsibilities of the audit committee would include overseeing the functioning of the financial reporting process, monitoring the choice of accounting policies and principles, monitoring internal control process and so on. One of the mandatory requirements of audit committee is to look into the reasons for default in payments to deposit holders, debentures, non-payment of declared dividend and creditors. Therefore, to perform such a function, the independent directors ensure proper, efficient and effectual monitoring system exists in the company.

Therefore the main role of independent directors is to improve corporate governance standards. However, the corporate should ensure that the independent directors are allowed to act independently for the institution of independent directors to be successful. By independence it means that the independent directors should have the will and the courage to say no when things are not moving in the interest of the company and its stakeholders. Independence has to be reviewed regularly as an instrument of good governance.

Myth Of Independence Of Independent Directors:

It is increasingly being recognized that the independent directors have a significant role to play in the progress of the company. This is based on the presumption that they are independent and not in any way affected by the promoters. The independence of independent directors is one of the questions which have come to the forefront time and again. It has been a subject of heated debate as to whether the independent directors are 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 the promoters and the management. The institution of independent directors was supposed to act as a bulwark against any opportunistic indiscretions that could be committed by the promoters and the management. This was done to promote investor protection through integrity and accountability. However, looking at the provisions relating to independent directors especially in the Listing agreement, the independence of independent director is highly jeopardized. This can be seen by looking at the various aspects with regard to the independent directors.

The first factor is with regard to the selection of the independent directors. As far as appointment of an independent director is concerned there is no selection procedure which has been spelt out by any committee or statutes worldwide. The committees have made an attempt to identify the number of independent directors who can be designated as the independent director in the board but to question as to how these members are selected was not addressed. There has been a lot of importance given to the word ‘independence’ of an independent director but the selection of the independent directors lie in the hands of the owners of the company or they are directly handpicked by the promoters. It is seen the promoters in control take decisions that they may not be in the interest of small shareholders, an independent director must keep in mind the interest of all stakeholders. This factor therefore is considered a severe blow to the very basis of the concept of independent directors. It therefore raises a serious conflict in impartial and independent discharge of duties by the independent director. Therefore, there needs to be proper criteria’s which needs to be laid down and such criteria must be disclosed at the annual report for the shareholders to have a view regarding it.

Another aspect is that an independent director is a part timer and therefore is not able to function in an efficient manner. It is seen that an independent director spends only about 18 to 20 hours a week on board meetings of the company. An independent director has no right to interfere in the day-to-day operations of company. They are supposed to support the management in getting the delivery of what the objectives of the company are to its shareholders. If a director cannot get into a company’s day-to-day operations, he cannot understand how it is governed and will not be in the position to fulfill his responsibilities. The main source of information is the Chief Executive Officer and it is his performance they are supposed to be monitoring. There is no separate law under which an independent director operates. In other words, he has no legal protection from the management so that he can raise his voice fearlessly. For the involvement of independent director in day-to-days operations of company they must be given authority so that they can intervene in the day-to-day operations of company and may be able to raise their voice. The corporate governance norms expect a lot from an independent director. Taking into consideration the fact that he is only a part timer, he falls acutely short of his time and is not able to perform his functions. It cannot be reasonably accepted that a person who is appointed by the owner will not have any allegiance to the person by whom he is appointed

Many independent directors are not technically and professionally qualified to head the committees they chair in the companies. It is seen that usually a person who is selected as independent directors are generally a person of high repute. However, there is no specific qualification that is laid down for the appointment of independent directors. The only eligibility criterion which has been laid down in the clause 49 of the listing agreement is based on negative prescriptions. The criteria which have been laid down is that they should not have a material or pecuniary relationship or should not be related to the promoters or be an executive in the company for the preceding three years. Therefore, there is not a list of positive qualification that has been laid down which would be considered appropriate for the role. The definition also ignores the fact that even eminent persons who are normally selected are associated with the board.

Conclusion:

Therefore amendment to the clause is no doubt a giant step taken to improve corporate standards in India. The appointment of independent director will no doubt lead to better governance and also help in the proper functioning of the company. However, to meet the objectives of corporate governance, the clause has to be further elaborated and the focus should be on the independent director being completely independent from the promoters. Therefore it is seen that the current legal framework makes a little effort to assess whether an independent director remains independent after his appointment. The eligibility criteria lacks laying down any relevant standard of professional competence that may be required to exercise oversight over the affairs of the management. In this context the clause should clearly have provisions regarding the minimum acceptable eligibility criterion that is required for the post of independent directors. The selection should be based on transparent and on certain valued basis. There should be an entirely different nomination committee in the company which should identify and evaluate candidates for nomination to the Board as independent directors.

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