4 Independent Directors: Role, Remuneration and Training

4.01 At the core of corporate governance lies the board of directors. A joint-stock company is owned by the shareholders, who appoint a board of directors to supervise and direct the management of the company and ensure that the board does all that is necessary by legal and ethical means to make the business grow to maximise long-term corporate value.

4.02 The first point to be noted is the one that is usually forgotten: viz., that the board is appointed by the shareholders and other key stakeholders, and are accountable to them. Simply put, the directors are fiduciaries of shareholders, not of the management. This does not imply that the board must have an adversarial relationship with the CEO and top management. Far from it. Most successful boards have remarkable collegiality and, more often than not, agree to most managerial initiatives. However, in instances where the objectives of management differ from those of the wide body of shareholders, the non-executive directors on the board must be able to speak up in the interest of the ultimate owners and discharge their fiduciary oversight functions. This is the reason why ‘independence’ has become such a critical issue in determining the composition of any board.

4.03 It was forcefully argued before us that while the Government does not hesitate to legislate for great expectations from independent directors, its own record of nominating directors on boards of public sector companies or banks has been less than exemplary. The Committee feels that just as the Government would like non-government companies to have independent directors of quality, it too should start nominating its directors on the basis of merit, rather than considerations that need no elaboration.

Definition of Independence

4.04 What, then, defines independence of directors? This is an issue that has vexed the minds of most corporate governance experts and has spawned myriad definitions. At the core, it means something very simple — a person should be able to exercise his or her reasoned judgement without being constrained or unduly influenced by pressures either from management or any dominant shareholder or stakeholder. To rephrase Bertolt Brecht, independence is a bit like communism: very easy to understand, very hard to achieve.

4.05 As a starter, an independent director must be a non-executive member of the board. This is obvious and doesn’t require elaboration. However, that is only the starting point. Independence is more than just being a non-executive director. The questions are: How much more? And how much of it should be mandated? The Report of the Kumar Mangalam Birla Committee on Corporate Governance (January 2000) discussed this matter and arrived at the definition given below:

“Independent directors are [those] who apart from receiving director’s remuneration do not have any material pecuniary relationship or transactions with the company, its promoters, its management or its subsidiaries, which in the judgement of the board may affect their independence of judgement.” [p.13].

4.06 In arriving at this definition — now mandated for listed companies through Clause 49 of the listing agreement — the Birla Committee was concerned that while “independence should be suitably, correctly and pragmatically defined”, it should be “sufficiently broad and flexible” so that it did not “become a constraint in the choice of independent directors on the boards of companies”.

4.07 While there might be merit in the pragmatism of the Birla Committee, we believe that the time has come to move away from such a circular and almost tautological definition and examine alternatives that follow the spirit of the Birla Committee while being in line with best international practices. There are five key reasons which have prompted us to examine somewhat more rigorous definitions.

  • First, thanks to Enron, Worldcom, Global Crossing and other international corporate scandals, much water has flown since January 2000 and today. In such a context, we believe that an inherently loose definition of independence will no longer suffice to attract domestic as well as international investor confidence.
  • Secondly, capital markets are now getting closely integrated. For instance, there are virtually no constraints today on either foreign equity funds investing in India or in Indian companies listing in the US or elsewhere. A definition of independence that is at considerable variance from other relevant international yardsticks can diminish the ability of Indian corporations to tap global risk capital at international prices — something that our companies have to do to grow in an increasingly globally competitive milieu.
  • Thirdly, global agencies such as Standard & Poor have already begun to rate companies according to corporate governance standards. Domestic rating agencies like CRISIL and ICRA have also got into this act. It is, therefore, both meaningful and strategically important for us to reconsider the Birla Committee definition and raise the bar.
  • Fourthly, in the course of our meeting with various stakeholders, we have felt that Indian investors, too, would be more comfortable with a somewhat tighter definition of independence.
  • Fifthly, while there seems to be shortage of adequate independent directors, we believe that this is neither a reflection of a serious supply problem, nor one arising out of the definition of independence. Simply put, there are enough capable people in India to play key fiduciary roles in boards of Group A, B1 and B2 companies — which together account for almost 95 per cent of market capitalisation. Good independent directors are not ubiquitous enough because they are not sought enough by companies, and because they are not adequately compensated for their time. If the compensation problem is taken care of, then it is feasible to attract better talent on boards, despite a more stringent definition of independence.

4.08 This brings us to various international definitions of independence. We examined definitions of General Motors Board Guidelines, Australia’s IFSA guidelines, France’s Hellebuyck Commission recommendations, the Hermes Statement, PIRC Guidelines, CalPERS Core Principles and Guidelines, TIAA-CREF Policy Statement, AFL-CIO Voting Guidelines, and several other recent ones.

4.09 After going through these, and keeping in mind pragmatic factors, the Committee came to the conclusion that the definition of independence can be made more precise without either compromising the spirit of independence or constraining the supply of independent directors.

Recommendation 4.1: Defining an independent director

  • An independent director of a company is a non-executive director who:
  1. 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;
  2. Is not related to promoters or management at the board level, or one level below the board (spouse and dependent, parents, children or siblings);
  3. Has not been an executive of the company in the last three years;
  4. Is not a partner or an executive of the statutory auditing firm, the internal audit firm that are associated with the company, and has not been a partner or an executive of any such firm for the last three years. This will also apply to legal firm(s) and consulting firm(s) that have a material association with the entity.
  5. Is not a significant supplier, vendor or customer of the company;
  6. Is not a substantial shareholder of the company, i.e. owning 2 per cent or more of the block of voting shares;
  7. Has not been a director, independent or otherwise, of the company for more than three terms of three years each (not exceeding nine years in any case);
  • employee, executive director or nominee of any bank, financial institution, corporations or trustees of debenture and bond holders, who is normally called a ‘nominee director’ will be excluded from the pool of directors in the determination of the number of independent directors. In other words, such a director will not feature either in the numerator or the denominator.
  • Moreover, if an executive in, say, Company X becomes an non-executive director in another Company Y, while another executive of Company Y becomes a non-executive director in Company X, then neither will be treated as an independent director.
  • The Committee recommends that the above criteria be made applicable for all listed companies, as well as unlisted public limited companies with a paid-up share capital and free reserves of Rs.10 crore and above or turnover of Rs.50 crore and above with effect from the financial year beginning 2003.

Composition and Size of the Board

4.10 According to the Birla Committee (and now in Clause 49 of the listing agreement as well as the Companies Act), at least 50 per cent of the board of a listed company should consist of non-executive directors. Furthermore, in the case of there being a non-executive Chairman, at least a third of the board should be independent directors; and if the Chairman is an executive, at least half the board should be independent.

4.11 We believe that there is no reason to make complex distinctions between non-executives and independents, or to create two different standards depending upon the executive or non-executive status of a corporate chairman. Further, the Committee felt that to be really effective, independent directors need to have a substantial voice, by being in a majority. In a country where promoters are directors in a large number of companies, there was obviously a counter view. On the balance, however, it was felt that rather than the management or the promoters, the Committee should put its weight behind minority shareholders and other stakeholders such as consumer or creditors. A question also arose regarding the ‘independence’, or otherwise, of the nominee directors of financial institutions. On one hand, it was felt that since these directors were not functional directors and had no personal interest, as such, in the company, they could be considered to be independent; on the other, it was argued that as representatives of the major creditors, these directors had a particular interest to safeguard, and could hardly be deemed to be independent from the point of view of other stakeholders and minority shareholders. The Committee, therefore, decided that in implementing the following recommendation, nominee directors should not be counted either towards the numerator, or the denominator.

Recommendation 4.2: Percentage of independent directors

No less than 50 per cent of the board of directors of any listed company, as well as unlisted public limited companies with a paid-up share capital and free reserves of Rs.10 crore and above, or turnover of Rs.50 crore and above, should consist of independent directors — independence being defined in Recommendation 4.1 above. However, this will not apply to: (1) unlisted public companies, which have no more than 50 shareholders and which are without debt of any kind from the public, banks, or financial institutions, as long as they do not change their character, (2) unlisted subsidiaries of listed companies. Nominee directors will be excluded both from the numerator and the denominator.

4.12 The Committee believes that Recommendations 4.1 and 4.2 will not only build upon the corporate governance measures already mandated by SEBI and the DCA, but also foster greater transparency through clearly verifiable, non-discretionary criteria. For instance, in the last two years, the discretion implicit in the phrase, “which in the judgement of the board…” has been often employed to classify several non-executives as independent directors — an arrangement that would have clearly failed the objective criteria set out in Recommendation 4.1.

4.13 Determining the ‘right’ size of a board is the matter for individual companies, and not a Government-appointed Committee such as ours. However, public limited companies access larger amounts of risk capital than their private limited counterparts; and listed companies access even larger risk capital and also have much more widely dispersed share-ownership. The negative effects of corporate scandals and concomitant failures, therefore, are much more for listed and large non-listed public limited companies than for the private limited ones. Given the greater fiduciary responsibilities of boards of listed and large unlisted public limited companies, the Committee felt that there is a case to suggest the minimum board size.

Recommendation 4.3: Minimum board size of listed companies

The minimum board size of all listed companies, as well as unlisted public limited companies with a paid-up share capital and free reserves of Rs.10 crore and above, or turnover of Rs.50 crore and above should be seven — of which at least four should be independent directors. However, this will not apply to: (1) unlisted public companies, which have no more than 50 shareholders and which are without debt of any kind from the public, banks, or financial institutions, as long as they do not change their character, (2) unlisted subsidiaries of listed companies.

Ensuring Independence of Judgement

4.14 Defining independence is necessary, but not sufficient to ensure independence of judgement. That has much to do with the choice of directors and the skills that they bring to the board; the conduct of board meetings; the quality and quantity of financial, operational and strategic information supplied by the management to the board; management’s appetite for independent evaluation and criticism of strategies and performance; the extent to which promoters and management truly want healthy debate and independent oversight; the de facto role of the various committees of the board; and, of course, how much a company is willing to pay for the experience and skill sets of professional, independent directors.

4.15 Many of these aspects are, and should be, beyond the pale of law and regulation. They are, nevertheless, critical. And it is therefore necessary to discuss some of them in reasonable detail.

Choice of directors and their skill sets

4.16 While it is important to follow the laws and regulations defining corporate governance, it should be self-evident that independent directors ought not to be chosen merely to comply with statutory requirements. Independent directors of respected, well- governed, board-driven companies are usually acclaimed professionals who possess clearly defined skills and attributes and requisite experience.

4.17 Naturally, the skill sets needed at the board level will vary across corporations as well as over time. However, international experience suggests that all boards benefit from a few specialised skills. One of these is financial expertise. At least one — and preferably two or three — independent directors ought to possess sound financial knowledge. This does not imply that such a director or directors necessarily must be chartered accountants. However, they should have sufficient skills and experience to carefully read profit and loss accounts, balance sheets, cash flow statements, notes on accounts, significant accounting policies, qualifications (if any), question internal and statutory auditors about their audit findings, and be able to satisfactorily conduct meaningful Audit Committee proceedings.

4.18 With global competition becoming more intense than ever before, the Committee also felt that it would be useful for boards to have independent directors who can comment, if not lead discussions, on a company’s business strategies, as well as its strengths, weaknesses, opportunities and threats. Despite major strides in corporate governance and disclosures in the last five years, most companies — including those listed in Groups A and B1 — still do not have enough independent directors who can contribute in this field.

4.19 Equally, given discontinuous leaps in the knowledge component of any product or service, human resource development has become a critical issue. How to design policies and strategies that attract, identify, nurture, motivate and reward the best talent — and penalise the chronic under-performers — will be more and more critical in separating the corporate winners from the also-rans. Here, too, the Committee felt that boards will benefit enormously from the services of those who have HR expertise.

4.20 The Committee noted four other areas that are also rapidly gaining prominence in modern business. These are (i) integrated logistics and end-to-end supply chains, (ii) R&D, (iii) the creation, maintenance and scalability of web-based IT systems that deal with internal processes as well as relationships with customers and vendors, and (iv) sophisticated, transparent investor relations. All these are key management functions where the initial expertise may be sought from various consulting firms and specialised service providers. Nevertheless, the Committee felt that it might be useful to have one or more independent director with some knowledge of these subjects.

4.21 These are not matters for mandating. The point to be emphasised is that the fiduciary responsibility of a board of directors goes far beyond ticking an exhaustive compliance check-list. No doubt, the compliance function is important, and has to be discharged with due diligence. Like quality, compliance is an irreducible given. However, boards of truly great global companies do much more than compliance. They strategise, help locate key inputs, identify growth drivers, steer the company from icebergs and shoals and, thereby play a critical role in maximising long-term corporate value. The Committee believes that better search processes, less onerous liabilities and significantly higher compensation for independent directors will help identify and induct much more talent into corporate boards of India.

4.22 The other point worth noting is that excellence attracts excellence. Respected, well-run and transparent companies in India have never faced the problem of getting top class independent directors. The market knows that such companies choose the best-in-class people, and give them the oversight strategic space that they would ordinarily expect. The Committee, therefore, urges companies in India to make a sustained effort to attract requisite talent at the board level — people who can contribute their expertise to make a difference not only to governance, but also to long-term corporate performance.

Duration and conduct of board meetings

4.23 With our penchant to legislate and regulate as much as possible, boards of Indian companies have always been over-burdened with a plethora of regulatory and statutory resolutions. If anything, these have significantly increased with Clause 49 of the listing agreement and recent amendments in the Companies Act. A typical quarterly or half-yearly board meeting can have anything between 25 to 30 resolutions that have to be debated and passed only in order to satisfy legal and regulatory requirements. Taken together, these resolutions can take up as much as an hour of the board’s time. Of course, the number of statutory functions increase significantly at the time of considering annual audited accounts.

4.24 A cursory glance at the timings of many board meetings will reveal that they begin somewhere between 10.30 am and 11 am, and conclude by 1 pm to 1.30 pm —in time for a well-earned lunch. Given the increasing amount of time needed to deal with pure regulatory and compliance issues, the Committee wondered how the boards and Audit Committees of a large number of Indian companies could have discharged their compliance obligations as well as their strategic functions in less than half a day.

4.25 It is not only difficult but also undesirable to mandate somewhat longer board meetings. Nevertheless, the Committee felt that there ought to be some disclosure about the timings of a listed company’s board and Audit Committee meetings. For that would allow shareholders to know how much time their appointed fiduciaries formally spend in discharging their oversight duties.

Recommendation 4.4: Disclosure on duration of board meetings / Committee meetings

The minutes of board meetings and Audit Committee meetings of all listed companies, as well as unlisted public limited companies with a paid-up share capital and free reserves of Rs.10 crore and above or turnover of Rs.50 crore must disclose the timing and duration of each such meeting, in addition to the date and members in attendance.

4.26 This is not a radical suggestion. Clause 49 already mandates that listed companies must fully disclose the attendance records of directors at board and board-level committee meetings in their annual report — a recommendation that was adopted from the Confederation of Indian Industry’s Desirable Corporate Governance: A Code (April 1998). This disclosure has played a major role in exposing absentee directors and, in many instances, has forced them to either improve their attendance or exit from the boards. The Committee believes that the additional disclosure mandated in Recommendation 4.4 will induce companies to allocate more time for their board and committee meetings which should, hopefully, improve their agenda and scope.

Tele-conferences and Video conferences

4.27 Members of the Committee felt that while all best-in-class independent directors have the ability and motivation to fully discharge their fiduciary duties, they occasionally find it difficult to attend board meetings. This is especially true for international directors — such as strategists and professors of business schools who are increasingly joining the boards of well-run companies. For them, it is sometimes difficult to travel for three days to attend two days of board and committee meetings. In today’s age of communication, this problem can be easily resolved.

Recommendation 4.5: Tele-conferencing and video conferencing

If a director cannot be physically present but wants to participate in the proceedings of the board and its committees, then a minuted and signed proceedings of a tele-conference or video conference should constitute proof of his or her participation. Accordingly, this should be treated as presence in the meeting(s). However, minutes of all such meetings should be signed and confirmed by the director/s who has/have attended the meeting through video conferencing.

Financial and non-financial information at the board level

4.28 Clause 49 of the listing agreement clearly mandates the information that must be placed before the board of directors. Adopted from the Report of the Working Group on the Companies Act (1997) , these disclosures are:

  • Annual operating plans and budgets, and up-dates.
  • Capital budgets and updates.
  • Quarterly results for the company, and its operating divisions or business segments.
  • Minutes of meetings of the audit committee and other committees of the board.
  • Information on recruitment and remuneration of senior officers just below the board level, including appointment and removal of the CFO and the Company Secretary.
  • Show cause, demand and prosecution notices which are materially important.
  • Fatal or serious accidents, dangerous occurrences, and any material effluent or pollution problems.
  • Material default in financial obligations to and by the company, or substantial non-payment for goods sold by the company.
  • Any issue which involves possible public or product liability claims of a substantial nature, including any judgement or order which may have either passed strictures on the conduct of the company, or taken an adverse view regarding another enterprise that can have negative implications for the company.
  • Details of any joint venture or collaboration agreement.
  • Transactions that involve substantial payment towards goodwill, brand equity, or intellectual property.
  • Labour problems and their proposed solutions.
  • Materially significant sale of investments, subsidiaries and assets which re not in the normal course of business.
  • Quarterly details of foreign exchange exposure, and the steps taken by management to limit the risks of adverse exchange rate movement, if material.
  • Non-compliance of any regulatory, statutory nature or listing requirements, and shareholder services such as non-payment of dividends, delay in share transfer, etc.

4.29 The Committee believes that this list of mandated disclosures is adequate to properly inform independent directors about the basic financial and non-financial state of the company. Only one more disclosure needs to be specified, and it relates to the press releases and analysts’ presentations made by companies.

Recommendation 4.6: Additional disclosure to directors

In addition to the disclosures specified in Clause 49 under ‘Information to be placed before the board of directors’, all listed companies, as well as unlisted public limited companies with a paid-up share capital and free reserves of Rs.10 crore and above, or turnover of Rs.50 crore and above, should transmit all press releases and presentation to analysts to all board members. This will further help in keeping independent directors informed of how the company is projecting itself to the general public as well as a body of informed investors.

4.30 Besides this, nothing further needs to be done at this stage to increase the list of minimum mandated disclosures at the board level. Having said this, it is necessary to observe that good board-driven companies usually spend one to two extra days each year for a ‘strategy retreat’ — where board members together with senior management discuss different dimensions of the company’s strategic map for the next few years.

Audit Committee and its Independence

4.31 Audit Committees are now mandatory under the Companies Act as well as Clause 49 of the listing agreement. Moreover, over three closely typed pages, Clause 49 exhaustively sets out the role, composition, functions and powers of such a committee, which are in line with some of the most stringent international standards — itself a testimony of the SEBI’s and DCA’s commitment to corporate governance. The law can hardly be bettered. And the Committee sees no reason to reproduce in this report the mandated Audit Committee guidelines in Clause 49 of the listing agreement. Readers can refer to these by looking up SEBI’s website(http://www.sebi.gov.in/).

4.32 One area, however, requires some legislative change. Clause 49 says that the Audit Committee of listed companies must consist exclusively of non-executive directors, of whom the majority must be independent. The Committee felt that this needed some improvement and tightening. There were doubts on the advisability of excluding nominee directors of financial institutions from audit committees. The Committee preferred to be consistent in not considering directors with a certain mandate to be really independent.

Recommendation 4.7: Independent directors on Audit Committees of listed companies

Audit Committees of all listed companies, as well as unlisted public limited companies with a paid- up share capital and free reserves of Rs.10 crore and above, or turnover of Rs.50 crore and above, should consist exclusively of independent directors, as defined in Recommendation 4.1. However, this will not apply to: (1) unlisted public companies, which have no more than 50 shareholders and which are without debt of any kind from the public, banks, or financial institutions, as long as they do not change their character, (2) unlisted subsidiaries of listed companies.

4.33 No doubt, all Audit Committees claim to do what is mandated. It is, however, moot whether Audit Committees of most listed and unlisted public limited companies have the capability or inclination to follow the spirit of the law. There are four major reasons why many Audit Committees are not functioning as well as they should.

4.34 First, there are skill gaps. While one member of the committee may be positioned as the one having “financial and accounting knowledge”, it is worth asking how deep that knowledge is, especially given the new accounting standards and complexities. Incidentally, this is not a unique Indian problem. Many Audit Committees of Fortune 1000 US corporations face similar problems.

4.35 Secondly, it takes a considerable amount of additional time for an Audit Committee to successfully discharge its obligations in letter and spirit. The members have to review internal audit processes, have detailed discussions with internal as well as statutory auditors, independently meet with the CFO and the finance team, examine audit plans, review the adequacy of internal control systems, follow up on fraud or irregularities, if any, evaluate the company’s risk management policies, get a fix on all materially significant legal agreements, look into all key aspects of the financial reporting process, ensure compliance with financial, accounting and stock exchange standards, and much more. These have to be done every quarter, and much more intensively before adopting the annual audited accounts.

4.36 Such tasks are quite substantial even for Audit Committees of companies known for their excellent financial housekeeping. They are monumental for others. In the early stages — the 12- to 18-month period that is needed for well intentioned companies to get their financial hygiene in order — it can take an Audit Committee five to seven additional working days per year for it to dutifully discharge its obligations. Few, if any, Audit Committee members are willing to commit to this extra time.

4.37 Thirdly, the problem gets compounded by inadequate remuneration of directors. Very few companies offer commissions on profits to the independent directors. And loss-making companies — where Audit Committee tasks are all the more critical — can offer no commission whatsoever. Naturally, nobody except one who is seeped in altruism will want to spend an extra five to seven days doing Audit Committee work, all for a sitting fee of Rs.5,000. So they don’t.

4.38 Fourthly, there is the issue of selective monitoring by regulators. All companies faithfully report the composition of their Audit Committees and frequency of such meetings, and synopsise their role and functions. More often than not, that is what constitutes the typical annual report disclosure. And the regulators and stock exchanges accept these ‘reports’ as such. Indeed, it could be argued that what is perhaps the most important statutory reform in corporate governance has not been adequately monitored by the SEBI, DCA or the relevant stock exchanges.

4.39 In the present circumstances — lack of skill, the extra time dimension, paltry compensation for directors, and inadequate regulatory oversight — it would be heroic to assume that most Audit Committees would immediately tone up their act and become best-in-class overnight. That would require significant upward revision of independent directors’ remuneration going hand in hand with some additional disclosures. However, it is also true that the process of change has definitely begun. At least two dozen Group A and a dozen Group B1 companies are now reported to have good Audit Committees — a significant improvement compared to five years ago. If we get the compensation, additional disclosures right and mitigate some of the unnecessary liabilities of independent directors, we should be able to have, in the next three to five years, well-performing Audit Committees for companies that together represent at least 75 per cent of India’s market capitalisation.

4.40 In what remains of this section, we set out recommendations on the desirability of having Audit Committee charters, and on a set of disclosures that ought to be mandatory for such committees.

Recommendation 4.8: Audit Committee charter

  • In addition to disclosing the names of members of the Audit Committee and the dates and frequency of meetings, the Chairman of the Audit Committee must annually certify whether and to what extent each of the functions listed in the Audit Committee Charter were discharged in the course of the year. This will serve as the Committee’s ‘action taken report’ to the shareholders.
  • This disclosure shall also give a succinct but accurate report of the tasks performed by the Audit Committee, which would include, among others, the Audit Committee’s views on the adequacy of internal control systems, perceptions of risks and, in the event of any qualifications, why the Audit Committee accepted and recommended the financial statements with qualifications. The statement should also certify whether the Audit Committee met with the statutory and internal auditors of the company without the presence of management, and whether such meetings revealed materially significant issues or risks.

4.41 We now move on to three key issues: remuneration of independent directors, legal liabilities of non-executive and independent directors, and the training of directors. The Committee wishes to emphasise that without addressing these three issues, one cannot expect sustainable, long-term reforms in corporate governance.

Remuneration of Independent Directors

4.42 The maximum sitting fee permitted by the DCA is Rs.5,000. Small wonder, then, that it is virtually impossible to get independent directors, except from the class of retired people and those who feel important by claiming that they are on many boards.

4.43 Some might argue that sitting fees underestimate independent directors’ pay. Profit-making companies are permitted to pay up to 1 per cent of their net profits as commission to the independent directors, and this could be quite a handsome amount in the Indian context. The argument is flawed logically and empirically. A look at the annual reports of the 3,723 companies belonging to Groups A, B1 and B2 of the BSE will reveal that no more than 5 per cent of this sample pay a commission on profits. To give an example, neither banks nor public sector enterprises can pay commissions to their independent directors.

4.44 The logical flaw is more severe. The need of the day is to get independent directors of the highest standards of skill and probity to discharge critical oversight functions for loss-making companies and help them to turn around. Consider two examples: one of a company whose profits have reduced from Rs.100 crore to Rs.10 crore over three years; and another of a company whose losses have been brought down from Rs.100 crore to Rs.10 crore over the same period. The independent directors of the former — who have presided over the decline in national wealth — can, in addition to their sitting fees, still share a commission of Rs.10 lakh. Their counterparts in the latter — who have supervised the re-building of national wealth — can only get their sitting fees.

In such a context, it is not surprising that non-profit making companies cannot get the services of the best independent directors, even though these are precisely the entities where such services are most needed. The Committee believes that we as a nation cannot hope to get the best talent on to the board rooms of corporate India with such remuneration structures. It is time for a major revamp.

Recommendation 4.9: Remuneration of non-executive directors

  • The statutory limit on sitting fees should be reviewed, although ideally it should be a matter to be resolved between the management and the shareholders.
  • In addition, loss-making companies should be permitted by the DCA to pay special fees to any independent director, subject to reasonable caps, in order to attract the best restructuring and strategic talent to the boards of such companies.
  • The present provisions relating to stock options, and to the 1 per cent commission on net profits, is adequate and does not, at present, need any revision. However, the vesting schedule of stock options should be staggered over at least three years, so as to align the independent and executive directors, as well as managers two levels below the Board, with the long-term profitability and value of the company.

4.46 The Committee believes that, if implemented, Recommendation 4.9 will play a major role in increasing the supply of first-rate independent directors and, in the process, genuinely improve the quality of boards throughout the country. The converse is equally true. Not implementing such a recommendation will stultify corporate governance reforms — which have just begun to take root in India.

Liabilities of Non-Executive and Independent Directors

4.47 No one would deny that, by virtue of being a fiduciary, an independent director must be liable for certain explicitly proven acts of omission and commission. For instance, wrongful disclosures by the Chairman and members of the Audit Committee in a company’s annual report should attract disqualification and stringent penalties. Equally, if non-executive directors had knowledge of unlawful acts by the management or the board and, despite such information, failed to act according to law, then they should be certainly legally liable for such infringements.

4.48 It is also true that Indian case law distinguishes between the liabilities of executive directors and their non-executive or independent counterparts. Section 5 of the Companies Act clearly defines an officer in default for contraventions committed by a company. These are (i) the managing director(s); (ii) executive or whole-time director(s); (iii) manager(s); (iv) the Company Secretary; (v) any person in accordance with whose instructions the board is accustomed to act; and (vi) any person who has been entrusted and charged by the board to be an officer in default, subject to his/her consent. It is only when none of these conditions hold that the board in its totality is considered liable as the officer in default under the Companies Act. Moreover, the DCA in a circular of 24 June 1994 further clarified that non-executive, independent directors would ordinarily not be prosecutable for corporate offences. Case law has also upheld this view.

4.49 Therefore, it would seem that non-executive, independent directors are generally far less liable for infringements of provisions in the Companies Act than their executive counterparts.

4.50 However, several bodies, associations and professionals who deposed before the Committee have expressed their concerns about criminal liabilities that fall upon independent directors on account of breaches in other laws. The Committee has been specifically informed about the serious liabilities arising out of:

  • The Companies Act — various provisions, such as those relating to filing of statement of affairs in winding up proceedings, non filing of Annual Reports with ROC, default in payment of debt etc.
  • The Negotiable Instruments Act — especially section 138 which deals with bouncing and dishonouring of cheques (issued by the management of the company).
  • The Factories Act — under which there have been repeated instances of non-executive directors, along with the occupier, being issued non-bailable arrest warrants.
  • The Industrial Disputes Act — under which, like the Factories Act independent directors have been threatened with prosecution along with executive directors and managers.
  • The Provident Fund Act and the Employees State Insurance Act — where outside directors have been threatened with criminal prosecution for a company’s non-payment of provident fund or pension dues, even in instances where there have been only technical infringements.
  • The Electricity Supply Act — under which electricity suppliers, especially the State Electricity Boards have brought cases of criminal breach of trust against all directors of companies irrespective of whether they are executive or non-executive and independent.

4.51 Not even the most stringent international tenet of corporate governance and oversight assumes that an independent director — who interfaces with the management for no more than two days every quarter — will be in the know of every technical infringement committed by the management of a company in its normal course of activity. Indeed, making independent board members criminally liable for such infringements is akin to assuming that they are, in effect, no different from executive directors and the management of a company. This is certainly not the case, and there is nothing in the literature of corporate governance to even remotely suggest that the role of an independent director is identical to that of his executive brethren. In fact, the principle is quite the opposite: independent directors are not managers; they are fiduciaries who perform wider oversight functions over management and executive directors.

4.52 At a more practical level, the Committee is of the opinion that it would be very difficult to attract high quality independent directors on the boards of Indian companies if they have to constantly worry about serious criminal liabilities under different Acts.

Recommendation 4.10: Exempting non-executive directors from certain liabilities

Time has come to insert provisions in the definitions chapter of certain Acts to specifically exempt non-executive and independent directors from such criminal and civil liabilities. An illustrative list of these Acts are the Companies Act, Negotiable Instruments Act, Provident Fund Act, ESI Act, Factories Act, Industrial Disputes Act and the Electricity Supply Act. Independent directors should also be indemnified from litigation and other related costs, as outlined in paragraph 4.54.

4.53 Going forward, there is one possible legal issue that has concerned members of the Committee. Clause 49 of the listing agreement as well as the new corporate governance provisions in the Companies Act have created three strata of directors: executive directors, non-executive/independent directors who are members or chairmen of Audit Committees, and other non-executive/independent directors. Clearly, executive directors are, and ought to be, more liable than their non-executive or independent counterparts. But, given the well-defined legal responsibilities of the chairmen and members of Audit Committees, it could be argued by some plaintiff or another that they are more liable than other non-executive or independent directors. In fact, in a recent case, the US Federal Court in Delaware ruled that members of the Audit Committee have a different relationship to the company than other non-executive, non-employee directors (Reliance Securities Litigation, District Delaware, 2001). It should not surprise us that such an argument could be raised, and a ruling made, in an Indian court as well.

4.54 In such circumstances, the Committee feels that it would be prudent for companies to purchase a reasonable amount of directors’ and officers’ (D&O) insurance. This should cover independent directors even after they have ceased to be directors, if the offences relate to the period when they were directors. Such policies pay for the cost of litigation and pecuniary penalties, if any, and hence mitigate the corporate and individual risk of being an independent director.

Training of Independent Directors

4.55 Finally, there is the problem in India about the training of directors. A professional might be able to give excellent corporate advice and guide a company in ways that maximise long-term shareholder value. But he or she might not be aware of the nitty-gritty of the rights, responsibilities, duties and liabilities of a legally recognised fiduciary. Barring corporate lawyers, chartered accountants and company secretaries, these technical aspects are not obvious to some of the best qualified directors. Fully understanding such issues requires specialised training.

4.56 Consider the minimal size of the task. Even if we were to limit the exercise to only listed companies belonging to Groups A, B1 and B2 of the BSE, we are still looking at 3,723 companies. Assuming an average board size of 7, and that 4 of them are independent directors, there will be almost 15,000 such directors coming on to corporate boards. More than two-thirds of such directors will need at least a couple of days of formal training. This is a mammoth mission. Even if one were to further limit this to Groups A and B1, we are talking about 776 companies and over 3,000 independent directors. This is an stupendous task.

4.57 The Committee understands that some business schools, few industry associations such as the CII and FICCI, and professional bodies such as the ICAI and ICSI are aware of the magnitude of the task. Some have also begun training and workshop programmes in selected cities of India. However, given the sheer size of the task, there is a need to recognise that DCA has a special role in promoting and encouraging training programmes in leading institutions such as the Indian Institutes of Management, industry associations, other institutes of repute, and in the Centre for Corporate Excellence that they intend to set up.

Recommendation 4.11: Training of independent directors

  • DCA should encourage institutions of prominence including their proposed Centre for Corporate Excellence to have regular training programmes for independent directors. In framing the programmes, and for other preparatory work, funding could possibly come from the IEPF.
  • All independent directors should be required to attend at least one such training course before assuming responsibilities as an independent director, or, considering that enough programmes might not be available in the initial years, within one year of becoming an independent director. An untrained independent director should be disqualified under section 274(1)(g) of the Companies Act, 1956 after being given reasonable notice.
  • Considering that enough training institutions and programmes might not be available in the initial years, this requirement may be introduced in a phased manner, so that the larger listed companies are covered first.
  • The executing bodies must clearly state their plan for the year and their funding should be directly proportionate to the extent to which they execute such plans.
  • There should be a ‘trainee appraisal’ system to judge the quality of the programme and so help decide, in the second round, which agencies should be given a greater role and which should be dropped.

4.58 The Committee believes that the funding requirement is quite modest — no more than Rs.5 crore to Rs.7 crore per year. The benefits are huge. A methodical execution of such a coherent training programme will create the knowledge base needed for otherwise very capable men and women to be first-rate independent directors.