At the outset, it is important to note that corporate governance primarily concerns itself with public companies. The balancing of profit making with public or shareholder interests assumes legislative importance where the public are substantially interested in a corporation or where the shareholders are greatly dispersed. Such companies are invariably listed companies, that is, their securities are available on specified markets for purchase by all members of the public.
The board as interlocutor
In our previous article here, we outlined the evolution and purpose of the board of directors (“BoD”). We understood how the BoD, placed between shareholders and the executive management, is primarily a tool to resolve agency problems that arise to shareholders because of the diversification of ownership and control. Briefly summarised, the agency problems of a corporation are threefold: (a) conflicts between shareholders and management, (b) conflicts between majority and minority shareholders, and (c) conflicts between the controllers (majority shareholders or the management) and other stakeholders (such as creditors, clients, and regulators).
The role of corporate governance and law is therefore to effectively manage these conflicts. The BoD makes high-level decisions and monitors the performance of the management. It acts as a key interlocutor in the process of effective monitoring and resolution of these agency problems. The structure and organisation of the BoD assumes importance in addressing these problems. Historically, the BoD has been composed of the representatives of controlling shareholders, executive management, and at times, non-executive persons (who were representatives of other stakeholders such as creditors), people of prominence, or people otherwise affiliated to the company. This mix, although representative of the corporation, does not by itself eliminate the possibility of the functioning of the BoD being captured by the controlling constituents, that is, the controlling shareholders or the executive management, whichever has greater control of the corporation either through ownership or decision-making. This may lead to the decisions of the BoD being challenged by stakeholders on account of conflict of interest. In these situations it is likely that such decisions will be invalidated by courts or under law as it is difficult for a BoD composed in such a manner to demonstrate independence of judgment in cases where conflict is alleged by the affected stakeholders.
The prescription of non-executive and independent decision-making
Globally, the modern composition mandate of the BoD prescribes a mix of constituents including shareholder representatives, executive directors, and non-executive and independent directors (“IDs”). This mix has its origins in the corporate jurisprudence of the United States and the United Kingdom, self-regulation by stock exchanges, and legislation. The prescription for non-executive and independent directors in the U.S. was formed as a response to judicial decisions that gave weight to the non-executive and independent character of decisions in evaluating the proper discharge of the fiduciary duties of the BoD in situations of conflict such as self-dealing transactions and takeovers and business reorganisations. Corporate and accounting scandals such as those related to Enron and Worldcom further brought the failure of proper BoD oversight and action under public scrutiny and led to the mandatory prescription under the Sarbanes-Oaxley Act, 2002 (“SoX”). In the U.K., the concept of board independence dates back to the establishment of committees studying corporate governance beginning with the Cadbury Committee Report, 1992 and culminating with the consolidated Combined Code on Corporate Governance, 2008. Thus, the need for board independence that we have discussed in the previous paragraph, rose sharply after various multinational corporate failures resulting mainly from poor executive decision making, non-compliance with good company practices, and the internal corruption that ultimately reflected inefficient and conflicted board oversight.
Board independence in India
In India, the Securities Exchange Board of India (“SEBI”) has spearheaded the adoption of board independence starting with the Kumar Mangalam Birla Report, 2000 which was followed by the Narayan Murthy Report, 2004. The mandatory prescription of board independence in the form of requiring a certain number of non-executive and independent directors was achieved via self-regulation in the form of Clause 49 of the listing agreement between the stock exchange and the companies. The Companies Act, 1956 was silent on the aspects of board independence and general directorial responsibilities.
In the wake of corporate governance failures such as those involving Satyam, further reform has been brought in place by the Companies Act, 2013 (“Act”), which now provides a legislative mandate for board independence, prescribes duties and responsibilities for the BoD, and fixes accountability on the actions of the BoD.
Importantly, the Act is the first Indian legislation to require corporate governance in the form of board independence not only from listed companies but also on public companies that (a) have a paid-up share capital of at least ten crore rupees, (b) have a turnover of at least one hundred crore rupees, or (c) have in aggregate outstanding loans, debentures, and deposits exceeding fifty crore rupees. Under the Act, listed public companies have to have at least one-third of its BoD consisting of IDs and the public companies (meeting the aforementioned criteria) are required to have at least two IDs.
The comprehensive and exhaustive criteria of independence for an ‘independent director’ (Section 2(47) read with Section 149(6) of the Act), which were missing from the Companies Act, 1956 are objective as well as subjective. One objective qualification to be an independent director is that a person cannot have any interests, pecuniary or real, in the company or its affiliates or with the promoters, directly or indirectly. The criteria that one must be a ‘person of integrity’ and ‘possess relevant expertise and experience’ are, on the other hand, subjective. The criteria also takes care to prohibit service providers such as accountants and legal professionals who meet specified thresholds in the form of pecuniary or transactional relationships with the company. It may be noted here that the Act for the first time lays down limits on the number of directorships an individual may hold simultaneously, namely, twenty for private companies and ten for public companies.
The roles and responsibilities of the IDs are expressly incorporated in Schedule IV of the Act. The Act mandates that the IDs have to exercise their judgments to take fair decisions in the interest of the company and the stakeholders and evaluate whether the BoD and the other directors are taking decisions safeguarding the interests of all the stakeholders. There are also broad guidelines prescribed for the IDs like upholding ethical standards of integrity, acting objectively, devoting sufficient time to ensure balanced decision-making in order to fulfil their duties and obligations such as assisting the company in implementing the best corporate governance practices and even to moderating and arbitrating in the interest of the company in situations of conflict between the interests of the company and shareholders. The Act gives enhanced significance to the role of the IDs to ensure that the companies are encouraged to follow the best corporate governance practices. In this regard, Section 173(3) of the Act requires that if the IDs are absent from any board meeting, any decision that is taken in the meeting shall be final only after it is ratified by at least one independent director. This provision also ensures that the board doesn’t arbitrarily take decisions in the absence of the IDs.
Board independence will be merely symbolic without adequate access to data and information, in the absence of which, even an independent director cannot be expected to discharge his function of oversight and control effectively. In order to ensure that the IDs are provided with enough data and information related to the affairs of the company, the Act mandatorily requires the companies to form various committees like the nomination committee, the remuneration committee, and the audit committee. Provisions have been made to involve the IDs in the decision-making of these committees by providing for conditions such as a minimum number of IDs or an ID as chairman of a committee.
Code VII of the Schedule IV of the Act requires the IDs to convene at least one meeting in a year without the presence of non-IDs and members of management which is called a ‘separate meeting’. The objective of conducting a separate meeting is to allow the IDs to discuss and evaluate the performance of the company, its chairperson, and other directors. It also allows the IDs to assess the quality, quantity, and timeliness of the flow of information between the management of the company and the board of the company which is necessary for effective and reasonable performance of the duties by the BoD. However, the powers of evaluation are reciprocal. The entire board also has the power to evaluate the performance of the IDs and the decision of whether to extend or continue the terms of appointment of the IDs is taken on this basis.
The SEBI has also brought in amendments to board independence requirements under the Model Listing Agreement to align it with the Act and adopt “best practices on corporate governance”. The provisions of Section 149(3) of the Act have been replicated by the SEBI in Clause 49(II)(B) of the Listing Agreement. The listing agreement also provides a limit on the number of directorships that a person can undertake while serving as an independent director. A person cannot serve as an independent director in more than seven companies at a time and if a person serves as a whole time director in any listed company, then the limit on his directorship as an independent director in other companies comes down to three.
Balancing the wide arena of responsibilities and obligations imposed on the IDs under the Act and to ensure that the IDs are not fastened with the liability in the affairs of the company where there is no involvement on their part, the Act provides that IDs may not be held liable for an offence by the company unless it is established that they had knowledge of the act and consented or connived in its occurrence. The Act provides that the “knowledge” of the ID can be attributed through board processes, therefore the records of a board meeting such as the minutes are enough to establish that the ID had “knowledge” of the act leading to an offence by the company. Further, the Act also provides that the ID may not be held liable if it can be proved that he acted diligently. There have been various judgments from the Supreme Court and several high courts where the IDs have not been held liable in the affairs of day to day management of the company. The liability instead, has been fastened on the people who had been in-charge of the affairs of the company and were responsible for the actions taken on behalf of the company. (See, Central Bank of India v. Asian Global Ltd., (2010) 11 SCC 203, National Small Industries Corpn. Ltd. v. Harmeet Singh Paintal, (2010) 3 SCC 330)
The reader may also note that the Act ushers in significant provisions regarding the constitution of the BoD and functioning of directors of the company. In our next article we will study the duties of directors (including IDs) from a legislative and judicial perspective and its impact on board independence and liability. We will also examine certain provisions of the Act which fix specifically liability on executive management or the BoD.
(Jitender Tanikella is a corporate and tax lawyer with an advanced law degree from Columbia University. Anirudh Rastogi is a general corporate lawyer with an advanced law degree from Harvard University. They are part of Tanikella Rastogi Associates.)
– llan, Kraakman, Subramanian, Commentaries and Cases on the Law of Business Organization, (Wolters Kluwer, 2009) 3rd ed., at 98.
– Umakanth Varottil, “Evolution and effectiveness of independent directors in Indian corporate governance”, Hastings Business Law Journal, Summer 2010, Volume 6, Number 2, Page 281.
– Jay Dahya & John J. McConnell, “Board Composition, Corporate Performance, and the Cadbury Committee Recommendation” (2005), available at http://ssrn.com/abstract=687429
– Erik Berglof and Ernst Ludwig von Thadden, “The Changing Corporate Governance Paradigm: Implications for Transition and Developing Countries” (1999), available at http://ssrn.com/abstract=183708
– Cadbury Committee: FINANCIAL REPORTING COUNCIL, REPORT OF THE COMMITTEE ON THE FINANCIAL ASPECTS OF CORPORATE GOVERNANCE (1992) available at http://www.ecgi.org/codes/documents/cadbury.pdf.
– Financial Reporting Council, The Combined Code on Corporate Governance, Jun. 2008, available at http://www.frc.org.uk/CORPORATE/COMBINEDCODE.CFM
– Report of the Kumar Mangalam Birla Committee on Corporate Governance (Feb. 2000), available at http://www.sebi.gov.in/commreport/corpgov.html.
– Report of the SEBI Committee on Corporate Governance (Feb.2003), available at http://www.sebi.gov.in/commreport/corpgov.pdf.