By Devaditya Chakravarti and Varun Chablani
The recently enacted Companies Act, 2013 (“Act”), has not only ushered in a new legislative framework but has also put in a place a new paradigm of corporate governance with detailed provisions as to appointment of independent directors. In the past few months, this model has been further bolstered by the clarifications issued by the Securities and Exchange Board of India ("SEBI") Circular dated April 17, 2014 [see end note1] and the Ministry of Corporate Affairs ("MCA") Circular dated June 9, 2014 [see end note 2].
The Satyam debacle raised a number of concerns on the role, effectiveness and responsibilities of independent directors. The Companies Act, 2013 seeks to rectify the lack of clear direction in the old Act and lay down in comprehensive detail a code for the mode of appointment, role and responsibilities, remuneration and extent of liability of independent directors. The new Act has made company law in India more globally compliant and meaningful in the realm of investor protection, timeliness and quality of disclosures, matters to be referred to the Board, scope of director’s role as well as related party transactions.
Number of independent directors
Framework under the Companies Act, 1956: The Companies Act, 1956 required independent directors to be mandatorily appointed only on Boards of listed companies. Clause 49 of the Listing Agreement applicable only to publicly listed companies set out the relevant provisions on the qualifications and number of persons to be appointed as independent directors; one-third of the board where the chairman is a non-executive director, or one-half of the board where the chairman is an executive director or a promoter.
Framework under the Companies Act, 2013: The newly-enacted Act, while conferring the Central Government with the power to prescribe the minimum number of independent directors has set out the kinds of companies that are required to appoint independent directors.
- Public listed company: Here, at least one third of the board is to be comprised of independent directors, and
- At least two independent directors need to be appointed in companies that fulfil any one of the following criteria
- Public companies having paid up share capital of INR 10 crores or more.
- Public companies which have, in combined, outstanding debentures, loans and deposits that exceed INR 50crores or more
- Public companies having a turnover of INR 100 crores or more
Additionally, the Nomination and Remuneration Committee of the Board should comprise of at least three non-executive directors of whom at least one half shall be independent directors for the abovementioned class of companies. The rules also require independent directors to be proficient in general management or specific disciplines that are relevant for the company’s business.
Section 135 of the Act also requires that appointment of at least one independent director out of 3 or more directors to the Corporate Social Responsibility (‘CSR’) Committee of the company which has a net worth of INR 500 Crores or more, or turnover of INR 1000 Crores or more, or net profit of INR 5 Crores or more during any given financial year. This is a rather favourable course correction in that independent directors can now exercise greater oversight over CSR activities and ensure that the company contributes to social, environmental, or economic development activities in an effective manner.
Prescribed criteria for qualification
Framework under the Companies Act, 1956: Clause 49 of the Listing Agreement defines "non-executive director" as a person who:
- Apart from receiving Director’s remuneration, does not have any material pecuniary relationships or transactions with the company, its promoters, its senior management or its holding company, its subsidiaries and associated companies;
- Is not related to promoters or management at the Board level or at one level below the Board;
- Has not been an executive of a company in the immediately preceding three financial years;
- Is not a partner or an executive of the statutory audit firm or the internal audit firm that is associated with the company, and has not been a partner or an executive of any such firm for the last three years.
- Is not a supplier, service provider or customer of the company and
- Is not a substantial shareholder of the company, i.e. owning two percent or more of the block of voting shares.
There have been several committee reports in the past which have delved into the meaning of independent directors by suggesting that majority of the directors of the company should be independent and "independent from management and free from any business or other relationship which could materially interfere with the exercise of their independent judgment"[see end note 3].
The Kumarmangalam Birla Committee Report states that "independent directors are those who apart from receiving the director's remuneration do not have any other material pecuniary relationship or transactions with the company, its promoters, its management or its subsidiaries, which in the judgment of the board may affect their independence of judgment" [see end note 4].
Framework under the new Companies Act, 2013: A considerable amount of detail is prescribed in the Act and relevant rules regarding the qualifications, number on Board and committees, expectations, duties and obligations, liability and manner of appointment and resignation. Section 149 (6) of the new Act defines an independent director as a person
- who is not a managing, whole-time or nominee director
- of integrity and experience in the Board’s view and
- With relation to a company, its holding, subsidiary or associate (“Entity”)
- Was/is not a promoter or related to any director or promoter of any of them
- Has/had no financial transaction/relationship of any sort with any Entity or their promoters or directors for current and previous two financial years
- Is not a CEO or director of a NGO that receives 25% funding from the company, its promoters or director
- Holds by himself/herself or with relatives in excess of 2% shareholding/voting interest in the company
- Relatives of such director have no pecuniary transaction with any Entity for the current or two previous financial years exceeding 2% of their gross turnover or income exceeding INR 5 million
- Relative/ director not a KMP, employee of any Entity for the preceding 3 years
- Relative/director was not a partner or employee for 3 preceding years of a firm of auditors, company secretaries, cost auditors of any Entity
- Relatives/director not a partner, employee for preceding 3 years of legal or consulting firm that was involved in any monetary transaction with an Entity exceeding 10% gross turnover of such firm.
The Listing Agreement provides that an independent director must not have "any material pecuniary relationship" or transaction with the company at the time of appointment as an independent director; the Act prescribes more stringent conditions and confines it to "any pecuniary relationship" with the company in the current financial year or the immediately preceding two financial years. This divergence has, however, been reasonably reconciled by the SEBI circular dated April 17, 2014 [see end note 5], applicable from 1st October, 2014. The Ministry of Corporate Affairs has recently clarified that any services provided to the independent director by a company that is provided on the same terms to any member of the general public (like telephone, insurance etc).
The Expert Committee on Company Law Report states that the term should be understood from the point of view of the recipient and not that of the company. 10% or more of recipient's consolidated gross revenue/receipts for the preceding year would be a material condition that could affect impartiality of the independent director. Also, any transactions with an entity in which the director or his relatives hold more than 2% shareholding should also be treated as materially affecting the judgment of the independent director.
The SEBI Circular has made peace with the position as it exists in the Act as it mentions that any person having any "pecuniary interest" in the company would stand to disqualify as an Independent Director [see end note 6]. The recently issued MCA circular [see end note 7] states that an independent director should have no pecuniary relationship with the company concerned or its holding/subsidiary/associate company during the current and last two preceding years. However, it goes on to state that the following transactions which have been undertaken by the independent directors under the above circumstances will not fall within the ambit of pecuniary relationship:
- transaction(s) done in ordinary course of business at arm’s length;
- receipt of remuneration by way of sitting fees;
- re-imbursement of expenses for attending board and other meetings;
- any profit related commission as approved by members.
This is a welcome move as there was a great deal of opacity as to what would not qualify as pecuniary relationship and the MCA has once and for all laid to rest such transactions that fell in no man's land. The authors believe that the disqualification as to previous two financial years under the Act is technically onerous as it disables those prospective directors who may have been the promoter or director of a counter-party or company which has been selected in the recent past through an independent tender process.
Threshold of liability
Framework under Companies Act, 1956: In this context, SEBI order [see end note 8] dated March 11, 2011 is still fresh in the minds of many where the three independent directors of Pyramid Saimara Theatre Limited were restrained by the regulatory board from discharging their role in any listed company for a period of two years. The same was done on the premise that the said directors had omitted in preventing false and misleading disclosures made by the company in its accounts. The company had apparently made out inflated profit margins and revenues through made-up entries. While the directors argued that they merely participated in board room discussions where broad policy matters were discussed, SEBI refused to accept that they could not be responsible for the day-to-day affairs of the company. SEBI reiterated the 'duty of care' test for non-executive directors when it came to financial reporting and stated in these many words:
"While the extent of responsibility of an independent director may differ from that of an executive director, an independent director has the duty of care. This duty calls for exercise of independent judgment with reasonable care, diligence and skill which should be reasonably exercised by a prudent person with the knowledge, skill and experience which may reasonably be expected of a director in his position and any additional knowledge, skill and experience which he has."
It went on further to state that the directors despite noticing numerous red flags in the flow of revenue, profits did not bother to ask the right questions at the right point of time. SEBI's ominous refrain went to the extent of deploring the conduct of the independent directors as a "disgrace to the institution of independent directors and the audit committee of a listed company".
The Companies Act, 1956 in its Section 5 characterized this situation as falling into the mischief of Section 5. It defined the term "officers-in-default" as including the managing director(s), the whole-time director(s), the manager, any director(s) who may be specified by the Board where the company does not have whole-time or managing directors.
The MCA in its circular dated 25th March, 2011 [see end note 9] brought about more clarity on this issue as it stated that penal actions against non-executive directors can be maintained only where the Registrar of Companies concludes reasonably that such directors are officers in default and have not acted diligently. A prosecution against them cannot succeed where the violation occurred without their knowledge or consent. It conferred discretion on the Registrar to confirm and verify before issuing notice to the non-executive director. This principle-based approach protected the non-executive directors from frivolous litigation based on rigid notions of culpability as they could be protected now in the event of their innocence.
Framework under Companies Act, 2013: The legacy of "safe harbor" provisions in the old Act has been continued in the new Act as well. The Act has been more of a balancing act as it assimilates the wide spectrum of the many obligations, functions and duties as are ordinarily imposed on independent directors. Under the penal framework of the new Act, the liability of independent directors is limited to matters which are directly relatable to them. To this extent, Section 149(12) limits the culpability "only in respect of acts of commission or omission by a company which had occurred with his knowledge, attributable through board processes, and with his consent or connivance where he had not acted diligently".
This legislative manoeuvre should hopefully instill confidence in the minds of otherwise competent and capable individuals for taking unfettered decisions who were until now apprehensive of taking up or continuing with their board positions. SEBI's order and the Satyam scam had a major role in serving as a serious disincentive following which several hundred independent directors relinquished their positions for fear of prosecution, unwarranted or otherwise.
The clarifications as provided by the MCA in its recent circular are purely from a procedural standpoint as it seeks to clear out the murky state of operation of the 2013 Act. With more coherence as to the definition of pecuniary relationship, the burden on businesses will definitely ease in the times to come. The authors here hope that with further representations having been made by industry associations and the new government itself for a review of the 2013 Act, the element of uncertainty surrounding company law reform in India will subside for good.
[The authors are Associates, Lakshmikumaran & Sridharan, Chennai]
- Corporate Governance in Listed Entities- Amendments to Clauses 35B and 49 of the Equity Listing Agreement, Circular No. CIR/CFD/POLICY CELL/2/2014,available at http://www.sebi.gov.in/cms/sebi_data/attachdocs/1397734478112.pdf (last accessed on 11th June, 2014)
- Circular No. CIR/CFD/POLICY CELL/2/2014 dated April 17, 2014 (“SEBI Circular”) w.e.f. October 1, 2014) (last accessed on 11th June, 2014)
- Report of the Cadbury Committee on the Financial Aspects of Corporate Governance, United Kingdom, 1992, ISBN 0 85258 913 1, Burgess Science Press, available at http://www.ecgi.org/codes/documents/cadbury.pdf (last accessed on June 10th, 2014)
- Report of the Committee Appointed by the SEBI on Corporate Governance under the Chairmanship of Shri Kumar Mangalam Birla, available at http://web.sebi.gov.in/commreport/corpgov.html (last accessed on June 10th, 2014)
- Supra note 1.
- Report of the Expert Committee on Company Law, http://www.mca.gov.in/Ministry/chapter4.html (last accessed on June 11, 2014).
- Supra note 2.
- SEBI Order, No. WTM/MSS/ID2/92/2011, 11th March, 2011, available at http://www.sebi.gov.in/cmorder/pyramidmar2011.pdf (last accessed on June 11, 2014)
- MCA Circular no. 8/2011 No.2/13/2003/CL V dated 25th March, 2011 (last accessed on June 13th, 2014)