Over the last decade and a half, the primary regulatory authority for the Indian capital markets, 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. Such focus assumes significance since most of corporate India comprises promoter driven companies where promoters are also the major stakeholders and effective representative bodies to protect the interests of public shareholders are non-existent. 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. Non-compliance would invite penalties such as suspension of trading and even delisting from the stock exchanges.  The main components of Clause 49 are defining internal controls and disclosures with regard to governance matters and include that –

•    not less than 50 percent of the board of a company shall comprise non-executive directors;

•    a company shall identify and appoint independent directors. Such appointees shall not comprise less than 50 percent if the chairman is an executive director; or less than one-third if the chairman is a non-executive director;

•    the board shall form a qualified and independent audit committee to exercise oversight on the company’s financial reporting process and not less than two-thirds of this committee shall comprise independent directors.

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 and to promote investor protection through integrity and accountability. Popular perception has it that corporate India has been too quick and eager to embrace corporate governance compliance in order to project a responsible image.

However, recent examples of questionable conduct propelled by greed and avarice in very reputed corporate houses have dented the forthright image that corporate India has been trying hard to project.  The nadir was touched recently in one of India’s marquee IT companies, Satyam Computer Services Limited, thereby exposing a telling tale of an almost farcical compliance with corporate governance standards. Satyam was a rather simple case of fictitious accounting to inflate income and siphoning off of funds by the promoters. The simplicity of the fraud exposed the poor implementation of corporate governance standards in India. Events like, the promoters being put behind bars, questionable audits by one of the Top 5 audit firms, the independent directors who unanimously approved the questionable proceedings having resigned in haste, the shareholders initiating class action suits in various jurisdictions and the state agencies acquiring management control to avoid a climactic collapse, were all achieved in quick succession.  The situation was made no less ironic as only recently, the World Council for Corporate Governance had feted Satyam with the Golden Peacock 2008 award for excellence in corporate governance.   The ‘Golden Peacock’ has been withdrawn since, but the damage to corporate governance edifice is not so easily reversible.

Such setbacks have brought the institution of independent directors under immense scrutiny and have demonstrated that even highly credible, qualified and educated people may not be able to exercise efficient corporate governance oversight and perhaps only provide a cosmetic gloss to the constitution of the board of directors.  These watershed events bring out a number of issues as regards corporate governance standards practiced by corporate India. Some of the key issues are:

Pursuit of independence

The regulatory requirements do not prescribe any methodology for the selection and appointment of independent directors who in practice are appointed at the behest of the promoters and substantial shareholders.  As such, the independent directors owe their board positions to predictable channels of influence and selection. They are not selected at the behest of the regulator or the public shareholders, the latter, surprisingly being the group whose interests they are supposed to protect.  As such, there exists a conflict between the manner of appointment and the functions that independent directors are supposed to discharge.

Independent Directors:  Business advisor or watchperson

It is widely debated 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 unjust enrichment by the promoters and the management.  While a business advisory role may sound ideal, it may not be practically achievable as independent directors are not in charge of executive functions, not privy to the day-to-day affairs and in practice discharge their duties only at the meetings of the board.

Their role also assumes importance given the fact that the directors have a fiduciary responsibility towards the company and by law the directors may face civil and criminal liability for their acts and omissions.  Notably, the Companies Act, 1956 which prescribes civil and criminal liability for directors, does not make any distinction for independent directors and even such directors can be held to be “officers in default”.  The institution of independent directors is the creation of regulatory requirements that are laid down by SEBI only.  Cases like Satyam and certain others, wherein the independent directors are facing criminal liability for acts of misfeasance by the board have raised considerable disquiet and nervousness in the independent directors’ community.

Upon critical examination, while proficiency and participation in management affairs may be an added advantage, the primary role of independent directors should be confined to exercising oversight from the fulcrum of public shareholders’ interest. Also, while independent directors have fiduciary duties and the same set of information rights as other directors, their liability in case of management affairs and omissions should be delineated.  Independent directors should not be expected to conduct themselves as investigative agencies and unless proven guilty of willful default, negligence or fraud, should not be subjected to civil or criminal liability. For example, an independent director should be considered to have discharged its functions satisfactorily by placing reliance on facts and figures presented by the management, particularly when no issue thereon has been raised by either the internal auditors or the statutory auditors.

Eligibility Criteria for Independent Directors

Rapid compliance with Clause 49 was never surprising because it was always easy to comply in letter.  The eligibility criteria as stipulated by Clause 49 are based on negative prescriptions, for example, independent directors should not – (i) have material or pecuniary relationships, (ii) be related to the promoters, or (iii) be an executive in the company in the immediately preceding three years.

However, with a single exception, the eligibility criteria do not list any positive qualifications to be considered appropriate for the role. The single exception is that all members of the audit committee of the board should be ‘financially literate’ and at least one member shall have accounting or related financial management expertise.  The eligibility criteria singularly lack laying down any relevant standard of professional competence that may be required to exercise oversight over the affairs of the management.

Lack of material or pecuniary relationship?

Clause 49 defines the ‘independence’ of directors through the lack of material or pecuniary relationship with the company.  However, payment of fee/compensation to independent directors can be fixed by the board subject to shareholders’ approval. In the absence of any regulatory limits, it is possible to fix the fee/compensation for independent directors that may be on par with executive directors provided shareholders’ approval is obtained.  Further, there is no limit on the stock options that may be granted to independent directors.  Accordingly, the lack of material or pecuniary relationship can be overcome by establishing a system of rewards for such independent directors.

Nominee directors as independent directors

The popular practice to appoint nominees of institutional shareholders as directors and designating them as independent directors needs to be re-examined. As expected, by the very nature of their appointment, such directors may be disposed towards protecting the interests of their principal shareholder rather than espousing the case of all public shareholders.

Way forward – Qualify and punish!!!

In order that corporate governance objectives are met through the offices of independent directors, it is imperative that certain structural changes are made to Clause 49. The clause should clearly lay down – (i) minimum acceptable professional qualifications for eligibility; (ii) appropriate limits on payment of fee, compensation benefits and stock options so as not to introduce an element of ‘reward’ for independent directors which could establish an incentive and preclude their objective judgment; and (ii) limit the number of independent directorships which a person can hold simultaneously.

A more robust enforcement framework than suspension of trading and delisting from the stock exchanges should also be considered, as such regulatory actions also affect the public shareholders who may not have committed any default leading to such non-compliance.

With regard to delineating legal liability of independent directors, the Companies Bill 2009 is a step in the right direction as apart from broader disclosures aimed at improving corporate governance, it also seeks to provide greater levels of protection to independent directors if they are not accomplices to wrong doings by the promoter-directors or other executives of the company.