The Oxymoron Of Independent Directors In India
With the rise in regulatory scrutiny and corporate sanctions, the importance of robust corporate governance mechanisms in protecting shareholders and ensuring the integrity of corporate operations has come to the forefront. Independent Directors are the counterpoise against managerial dominion within corporations. Highlighted by the Cadbury report, the inclusion of independent directors was seen as a critical measure to mitigate conflicts of interest, enhance transparency, and safeguard the interests of diverse shareholders. Their placement is regulated by the corporate framework formulated by the Companies Act, 2013, coupled with the Securities Board Exchange of India (“SEBI”) Regulations. However, these provisions have often been manipulated in India at the hands of controlling managers or promoters who bend these provisions for self-serving interests depreciating the system of good corporate governance the country strives toward.
The authors, through this paper, aim to analyse the existing provisions surrounding Independent Directors and highlight the legislative loopholes that controlled entities circumvent. Further, through a comparative legislative analysis, the authors provide measures to be implemented to bridge the gap between regulatory intent and corporate practice. The article ultimately answers the question of whether independent directors are independent, and if not, how can we make them independent?
Domestic Framework
Section 149 of the Companies Act mandates the appointment of Independent Directors (“ID”) in listed companies, specifying that at least one-third of the board must comprise such directors. This requirement aims to ensure that there are individuals on the board who are not involved in the day-to-day operations and who maintain independence from the company’s management. However, recent reports suggest that there is a decline in the appointment of IDs in the country, indicating that corporates are inclining towards a lack of accountability and transparency. After the Satyam scandal, approximately 350 IDs nationwide have resigned from their posts, further indicating that all is not well within corporate boards.
SEBI’s final order in the matter of LEEL Electricals Ltd. (“LEEL”) fined two independent directors INR 10 lakh each for failing to discharge their statutory duties as members of the Audit Committee (AC). These directors were assured by the promoters that their roles would not require specialised knowledge of law or finance and that AC meetings were routine, with actual decisions being made in board meetings. Despite this, SEBI held them liable, highlighting their lack of financial proficiency and understanding of their roles, particularly in monitoring the end-use of funds raised through Global Depository Receipts (GDRs).
A similar situation occurred in the Fortis Healthcare Limited (“FHL”) case, where funds were diverted for the benefit of promoter entities, leading to artificial inflation of bank balances and misrepresentation in FHL’s financials. Here, independent directors claimed to rely on reports from fellow AC members and officials of FHL’s subsidiaries. One director, a medical practitioner, argued that his expertise was in medicine, not finance. Nevertheless, SEBI found them liable, emphasising that their responsibilities extend beyond the company to the public and the economy at large. For IDs not on the Audit Committee (AC), the liability is often liberally construed in their favour by SEBI; however, in the matter of M/s. MPS Infotecnics Ltd. (“MPS”), a non-executive independent director, was instructed by the board to execute an Account Charge Agreement with a foreign bank, which was part of a fraudulent scheme involving the misuse of GDR proceeds. The director, unaware of the scheme, signed the document bona fide on behalf of the company yet was still implicated due to the fraudulent outcome.
SEBI continues to take a stricter construction in stark contrast to the ratio in Sunita Palita vs. M/s Panchmani Stone Quarry, wherein the Court established that independent directors (IDs) cannot be held liable for wrongdoings if they are not involved in the day-to-day operations of the company. However, in SEBI’s orders in the LEEL and FHL cases, SEBI imposed significant liability on IDs for financial misconduct, even in the absence of their direct involvement.
Section 149(6) outlines the criteria for an independent director, stating that individuals must be free from any material relationship with the company that could impair their judgment. However, India hosts multiple instances, such as in the Satyam fiasco, wherein these IDs are often hand-picked by the promoters of the company, impairing their ability to be impartial. Additionally, Section 149(10) and Section 149(11) of the Act are designed to protect the tenure of independent directors, stipulating that they should serve a term of 5 (five) years, with the possibility of reappointment for 1 (one) additional term. However, as shown by the Tata case wherein an ID was removed for voicing his opinion, removal is left to the whims and fancies of the managers, further disrupting the ID’s role in ensuring good governance.
Liabilities associated with the role of Independent Directors are another significant concern. Despite Section 149(12) offering some degree of protection, the conditional nature of this immunity means that IDs can still be held accountable under breaches of the Factories Act, 1948, Labour Laws, or Environmental Protection Act,1986, exposing them to legal and financial repercussions. Further, due to companies in India often having a cohesive unit of controlling shareholders, the ID may not be able to touch upon sensitive questions due to the lack of transparency in the company’s workings. This creates the information asymmetry problem, as critical information is either selectively shared or withheld from them, which hampers their ability to make informed decisions. Despite their reliance on the data provided by the company’s management, IDs are still held liable for decisions made based on incomplete or misleading information. This situation undermines the very essence of their role, which is to provide unbiased oversight.
Thus, the concept of IDs is merely an oxymoron in the Indian context, as their appointment, extension of term, removal and remuneration are all controlled by the majority shareholders.
The Agency Problem
The corporate law framework in India has been drawn from Anglo-American practices and available literature. Thus, the international corporate law framework was formulated after considering societal factors and various empirical data affecting solely their economies, and hence is not mechanized to efficiently work in countries such as India. This indicates that adopting similar legislation in India without attuning the same to various local factors may not have the same intended consequences as international legislation. Consider, for example, the initiation of independent directors to prevent the agency problem. The underlying issue this form of governance seeks to mitigate is the ‘agency problem’. However, the agency problem faced by India, as opposed to that of the USA and UK, is fundamentally different. Say the agency problem is divided into three aspects (i) conflicts among managers & shareholders, (ii) conflicts among minority & majority shareholders, and (iii) conflicts among the owners & other parties with whom the firm contracts.
The USA and UK houses a system of diffused shareholders, with investors holding sizeable shares but not nearly enough to control a portion of the company. This asymmetrical distribution of power, classified as the ‘Outsider model’ of corporate governance, allows board decisions to often be based on separate agendas to further their interests rather than the interests of the shareholders, resulting in an agency problem between the managers and the shareholders. This dispersion of equity allows minority shares to be protected and creates an efficient system of separating control and ownership.
On the contrary, the Indian corporate system is dominated by family-run industries or holds large shareholders. Varottil describes this as the ‘Insider model’ of corporate governance wherein a cohesive group of insiders control the workings of the company. This results in conflicts not between control and ownership like the previous systems but between minority and majority stakeholders. Additionally, Juan Ma’s study on independent directors in China highlights three key points, underscoring the inherent contradictions in the role. First, dissent typically coincides with a deterioration of social ties between the independent director and the board chairperson, often occurring either after the chairperson’s departure or shortly before it. Second, dissenting directors faced punitive measures, including a significant increase in their likelihood of exiting the director labour market and an estimated annual income loss exceeding 10%. Third, while dissent might suggest robust corporate governance, it generally led to a 0.97% decline in the firm’s share price on the day of the announcement.
Thus, it is evident that the present Western model tailored to the affliction of managers vs shareholders cannot have the intended consequences for India unless it is integrated into various local factors pervasive in the country.
Appointment of Independent Directors
Another prong of the issue, arguably the most crucial to the independence of IDs, is concerned with the appointment of Independent Directors. Section 150 of the Act allows listed companies to pick and choose IDs from the databank maintained by the Indian Institute of Corporate Affairs. The FICCI GT survey reveals that a majority of respondents (56%) do not have a nomination committee responsible for identifying and appointing directors. It appears that the common practice has been for promoters to select individuals known to them or, alternatively, individuals who are well-known personalities that can enhance the board’s visible credibility. This approach naturally limits the pool of candidates to a relatively small segment, which explains why the second most populous country in the world faces challenges in finding independent directors. The Kumar Mangalam Birla Committee on Corporate Governance criticised the traditional practice of hand-picking independent directors, arguing that this method inherently compromises their independence. Despite these criticisms, this issue remains unresolved and presents a paradox: how can a director truly be independent if their appointment is reliant on the promoters who selected them?
In the UK, the Corporate Governance Code (“UK Code”), applicable to companies listed on the London Stock Exchange, requires that at least half the board, excluding the chair, be composed of Independent Non-Executive Directors (NEDs), with the chair expected to be independent upon appointment. Furthermore, IDs must chair key committees such as the audit and remuneration committees, ensuring independent oversight over critical areas. In the United States, the regulatory framework is shaped by the Sarbanes-Oxley Act and the listing requirements of major stock exchanges such as the New York Stock Exchange (“NYSE”)[1] and National Association of Securities Dealers Automated Quotations (“NASDAQ”). Both NYSE and NASDAQ require that a majority of the board is comprised of independent directors. The Sarbanes-Oxley Act mandates that all members of the audit committee be Independent Directors, which is crucial for overseeing financial reporting and disclosures. Singapore’s approach, codified in the Code of Corporate Governance and the Companies Act, mirrors many aspects of the UK and US frameworks. The Code stipulates that at least one-third of the board should be Independent Directors, with this proportion increasing to half if the chairman is not independent.
In the US, a nomination committee, comprised entirely of Independent Directors, spearheads the identification, evaluation, and nomination of new IDs. Similarly, the UK Code stipulates that a nomination committee, predominantly made up of NEDs, is responsible for proposing candidates to the board. This contrasts with the Indian system, where the board, including executive directors and potentially the company’s promoters, has significant influence over the selection of IDs. Although the Companies Act 2013 and SEBI regulations mandate certain criteria for independence and necessitate shareholder approval, the initial stages of the nomination process remain closely tied to the entity’s existing power structure. Consequently, the potential for conflicts of interest is higher, and the true independence of the directors becomes compromised. By having a nomination process driven by other Independent Directors, as seen in the US and UK, the selection is more likely to be impartial and free from internal biases, thereby strengthening the governance framework and enhancing the overall integrity and accountability of the board.
Path Forward
The nomination board set up in foreign jurisdictions , as stated above, comprising of other IDs, must be set up in India to oversee and regulate the appointment, renewal, and termination of tenure. Additionally, the remuneration, which is presently left to the private entity, must be regulated and centralised in order to ensure the independence of IDs. Furthermore, until a more stable and loophole-free system is established, the liability of IDs should be suspended, ensuring they are protected from undue risks. This interim protection, considering mass resignations, will encourage the revival of these crucial roles.
Conclusion
While the concept of independent directors is essential for good corporate governance, its implementation in India is fraught with challenges due to the unique agency problems and control dynamics in Indian corporations. To achieve true independence and effective corporate governance, India must adapt its framework to include impartial nomination committees, regulated remuneration, and interim liability protections for IDs. By aligning these practices with the unique corporate landscape in India, the country can bridge the gap between regulatory intent and actual corporate practice, ensuring that independent directors can adequately fulfil their oversight roles
