Measuring the Independence and Performance of the Independent Director

by Mr Suraj Choudhary (B.A., LL.B (Hons.) 2009, JGLS

The inclusion of independent directors on the Board of Directors is considered integral to the corporate governance framework. In India, most of the companies are closely held by promoter groups from the same family. The average promoter shareholding in BSE 500 companies is estimated to be over 50%. Hence, in order to counter the dominance of promoters and business families, and to safeguard the interest of all other stakeholders, it has become critical to have an independent voice in the Boardroom.

In India, the concept of independent directors was first introduced through voluntary guidelines issued by the Confederation of Indian Industry (“CII”). In 2000, the recommendations provided in the Kumar Mangalam Birla Committee Report prompted the Securities Exchange Board of India (“SEBI”) to include clause 49 in the Listing Agreement, which made appointment of independent directors sine qua non for listed companies or companies intending to be listed; the Listing Agreement has no application to companies that do not intend to be listed.

The Companies Act, 2013, (the “Act”) has introduced the concept of mandatory independent directorship, thereby requiring all companies, irrespective of whether they are listed, non-listed, public or private companies. Section 149(6) of the Act has defined the term ‘independent director’ in relation to a company. Accordingly, an independent director means a director other than the managing director or a whole-time director or nominee director.

An independent director should have or have had no direct or indirect pecuniary relationship with the company, its holding, subsidiary or associate company, or their promoters, or directors, during the two immediately preceding financial years or during the current financial year. To make the definition more stringent, pecuniary relationships with group companies within the same promoter group are also be included as a parameter for determining the directors’ independence.

The Act proposes to limit the tenure of independent directors to two terms of five years each. The Act mandates at least 1/3rd of the total number of directors should be independent directors in a listed company.

The Act also provides that the performance evaluation of the independent directors shall be done by the entire board of directors, excluding the director being evaluated and a report of performance evaluation would be prepared. This report will determine whether the term of appointment of the concerned director should be extended.

Lacunae and Suggestions

The remuneration paid to the independent directors by the company is a key factor that may give rise to an inherent conflict of interest. It is important that the remuneration package of the directors is tapped as a potential instrument for maintaining independence of independent directors. This may be done by linking remuneration with the performance of the company. An independent director’s ability to act independently from management is directly proportional to the remuneration offered to him.

The existence of exclusive and capped compensation would add little or no value to the object behind the provisions enactment and would prove as a hindrance in the way of the directors seeking to add value to the company by exerting over and above what is required by them. Independent directors may also be reluctant to disturb the collegiality and conviviality of collective decision-making, thereby precluding themselves from effectively discharging their roles. After a thorough scrutiny, it emerged that Satyam’s board of directors had unanimously approved a proposal to acquire two firms promoted by Raju’s family — Maytas Infra and Maytas Properties. The Serious Fraud Investigation Officer (“SFIO”) concluded that the independent directors were kept in the dark by A. Ramalinga Raju. Some of the independent directors later stated the approval for Maytas was not unanimous because it was subject to certain conditions.

Quick on the heels of the Satyam imbroglio, came the scandal where the very whistle blowers of corporate governance were found guilty of insider trading. One such case is that of Mr. V.K. Kaul, an independent director in a pharmaceutical major, who was found guilty of insider trading by the Securities Appellate Tribunal (“SAT”).

Further, the Act provides for two terms to change the composition of the boards which leaves room for persons, who have been on the Board for long tenures, to potentially serve further two terms as independent directors of the company. Therefore, the changes that the Act seeks to bring in independent functioning of the Board will come into effect ten years down the road in listed companies, which already have independent directors on their Boards. Moreover, the one year provided to companies to appoint independent directors is too short, and may prevent thoughtful appointments in the first tenure.

In India, we place an unrealistic expectation from our independent directors which needs to be tempered in the face of current laws. Relying overly on a singular metric as the key gate keeper may not safeguard stakeholders' interests. We continually need to remind ourselves that the only role of the independent director is to make sure that the rights of the minority and small shareholders is not abused and that is what he should be judged for.

It is also suggested that the requirement of performance evaluation for directors be made mandatory. The importance of performance evaluation of independent directors is such that the Standing Conference of Public Enterprises (“SCOPE”), the apex body of public sector undertakings (“PSU”), is developing a matrix for rating the performance of independent directors in PSUs. Such evaluation report of the independent director may be based on his attendance and contribution to the board/committee meetings and such appraisal may be placed before the nomination committee for taking a decision for re-appointment. This process of critical analysis of the performance of independent directors will not only enable the directors to focus more on their area of weaknesses but it will also build on their strengths enabling them to add value to the company.