Role and Responsibilities of Independent Directors in Corporate Governance
Independent directors play a crucial role in ensuring governance, accountability, and transparency within companies. They are required to possess integrity, expertise, and independence, as defined under the Companies Act, 2013. The duties include overseeing strategic decisions, assessing risks, and representing the interests of stakeholders while upholding legal and fiduciary responsibilities.
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Independent Directors: Functions, Responsibilities & Accountability. Dimensions of the office of the Independent Director in India.
Governance Challenges in Contemporary Business Environment Corporate Reporting: Enhanced disclosures & Responsibility Greater focus on strategy, long-term value creation and Reputation Key Governance Issues for companies in 2015 Stakeholder value, Responsibility Towards Society Board composition, diversity and boardroom effectiveness Shareholder Engagement & Activism. Heightened Proxy Advisory interventions
What defines an Independent Director? Integrity.Threshold defined under the Companies Act (CA), 2013 and additionally assessed by the board of directors and self- attested by the ID. Integrity Independence. Assessed in terms of an IDs relationships with the company/ promoters/ management. Not having held relationships (personal, familial) excluded under CA 2013. Expertise. a combination of subject matter expertise, industry exposure and past board experiences. Expertise professional, Independence Independent Director is defined u/s 149(6), CA 2013, as a director other than managing director, whole-time director or a nominee director, one who qualifies the tests of Integrity, expertise and experience and fulfils the exclusionary relationships test, as laid down under the law.
Independence defined A person of Integrity Integrity is not defined in law. Black s Law Dictionary defines integrity of a person to mean soundness of moral principles and character. The test of Integrity is done through an subjective assessment by the Nomination Committee and the board of directors against minimum legal standards or enhanced standards. Relevant expertise and experience Independent Directors should possess an appropriate balance of skills, experience, and knowledge of one or more areas like finance, law, management, sales, marketing, administration, research, corporate governance. Exclusionary Relationships Section 149(6), CA 2013 e.g. An Independent Director must not be related to the promoters of the company, and must be independent of the management of the company. Apart from director s remuneration, has or had no pecuniary relationship with the company, its holding, subsidiary or associate company, or their promoters, or directors, during current as well as two immediately preceding financial years Restrictions on company shareholding. (self plus relatives shareholding < 2% of company s total voting power). No restricted professional relationships current or previously held.
Fiduciary Duties Independent directors hold their position in a fiduciary capacity. Their legal duties are embodied by the principles of fiduciary duty. The expression fiduciarycapacity implies a relationship that is analogous to the relationship between a trustee and the beneficiaries of the trust. It extends to all such situations as place the parties in positions that are founded on confidence and trust on the one part and good faith on the other. Sri Marcel Martins vs. M. Printer & Ors. (SC) The fiduciary is expected to act in confidence and for the benefit and advantage of the beneficiary, and use good faith and fairness in dealing with the beneficiary or things belonging to the beneficiary. CBSE and Anr. Vs. Aditya Bandopadhyay and Ors. (2011) 8 SCC 497 Fiduciary duty is broadly categorized into, Duty of Care and Duty of Loyalty.
Duty of Care Duty of care entails that decisions by directors are made after due deliberations, balance in judgement and in awareness of key facts and information. Section 166 (3), CA 2013. Duty of care imposes upon directors a duty of competence or skill to act with a certain level of skill, and a duty of diligence. Duty of care requires directors to inform themselves of all material information reasonably available to them, prior to making a business decision. Smith v. Van Gorkom, 1985). 488 A.2d 858, 872 (Del. Directors must act in an informed and deliberate manner prior to making a business decision. Gross negligence is the standard in determining if there has been a breach of the duty of care. In re Walt Disney Co. Derivative Litigation, 906 A.2d 27, 53 (Del. Ch. 2006).
Duty of Care as established by Indian Courts Duty of care entails a duty to act with reasonable prudence, includes duty to seriously deliberate matters that comes before them. It includes the duty not to be oblivious to what is obvious. Supreme Court in Official Liquidator v. PA Tendolkar (AIR 1973 SC 1104), held: a director cannot shut his eyes to what must be obvious to everyone who examines the affairs of the Company even superficially. If he does so he could be held liable for dereliction of duties undertaken by him and be compelled to make good the losses incurred by the Company due to his neglect even if he is not shown to be guilty of participating in the commission . Test of Reasonable Prudence calls for exercising prudence as expected of a person having equivalent knowledge and experience. Duty of care for an independent director calls for exercise of independent judgment with reasonable care, diligence and skill which should be reasonably exercised by a prudent person with the knowledge, skill and experience which may reasonably be expected of a director in his position and any additional knowledge, skill and experience which he has . SEBI order in matter of Pyramid Saimira Theatre Ltd. (2011).
Tests of Due Care, Skill and Diligence Duty of Reasonable Skill, Care and Diligence Due care entails directors to take decisions after due deliberations, in consideration of key facts, and subject to verifiable checks. SAT in the Pyramid Saimira case (2012), referred to the English case of Equitable Life Assurance Society [(2003) EWHC 2263 (Comm)], to establish the dimensions of duty of care . Directors have, both collectively and individually, a continuing duty to acquire and maintain a sufficient knowledge and understanding of the company's business to enable due discharge of duties as directors. Whilst directors are entitled to delegate particular functions to those below them in the management chain, and to trust their competence and integrity to a reasonable extent, the exercise of the power of delegation does not absolve a director from the duty to supervise the discharge of the delegated functions.
Tests of Due Diligence According to Words and Phrases by Drain-Dyspnea (Permanent Edition 13A), due diligence in law means doing everything reasonable, not everything possible . It means reasonable diligence; it means such diligence as a prudent man would exercise in the conduct of his own affairs. Ref. Supreme Court order in Chander Kanta Bansal v. Rajinder Singh, (2008) 5 SCC 117 The test of diligence is essentially fact-based. Tests of Diligence, SAT in the Pyramid Saimira case (2012) Demonstrate due care and diligence while verifying documents placed for approval in board meetings. Identify deficiencies wherever possible by employing verification and scrutiny expected of a prudent man. A director cannot take a stand that he has approved the documents totally depending on the integrity and expertise of the management. While functions may be delegated to professionals, the duty of care, diligence, verification of critical points by directors cannot be abdicated.
Demonstrating Diligence Adequate attendance and preparation for the role by attending most meetings; Have all documents, papers, presentation, minutes archived in an intranet to demonstrate due process Raise relevant questions at meetings, and seek answers to them; Where not satisfied with the answers that affect the overall interests of the company, express dissent; and adequately record in minutes( needed under the law); Where there are concerns about running of the company or a proposed action, ensure they are addressed by the Board. Also, insist that the concerns raised by IDs with respect to the unresolved concerns be recorded in minutes. When any action is delegated, there must be an effective oversight. Engage services of an external expert, wherever considered necessary esp. in matters involving minority interests. Since independence is measured in action, act in a manner that is established by due process
Duty of Loyalty Duty of Loyalty requires that directors act in the interest of the company . Under Companies Act, 2013, a director is required to act in good faith to promote the objects of the company for the benefit of its members and in the best interests of the company, its employees, shareholders, community and for protection of environment. - Section 166(2), CA 2013. The definition is broad in the respect that it requires ensuring a collective benefit of key stakeholders, including its shareholders. Independent Directors are required to ensure that interests of all stakeholders, particularly minority shareholders, are duly considered as part of Board deliberations. Duty of loyalty, as interpreted by courts, means that acts and deeds of directors must be exercised for the benefitof the company. Dale And Carrington Invt. P. Ltd. vs P.K. Prathapan and Ors. 2004 Supp.(4) SCR 334.
Duty of loyalty contd. Duty of Loyalty Duty of Loyalty requires directors not to engage in transactions that involve a conflict of interest. Under Section 166(5), CA 2013, a director shall not achieve or attempt to achieve any undue gain or advantage, either to himself or relatives, partners or associates. Directors have an affirmative duty to protect the interests of the corporation, but also an obligation to refrain from conduct which would injure the corporation and its stockholders or deprive them of profit or advantage. Ivanhoe Partners v. Newmont Mining Corp., 535 A.2d 1334, 1345 (Del. 1987). The acts of directors in a private limited company are required to be tested on a much finer scale in order to rule out any misuse of power for personal gains or ulterior motives. Dale And Carrington Invt. P. Ltd. vs P.K. Prathapan and Ors. (SC) 2004 The Delaware Supreme Court in Stone v. Ritter said, [w]here directors fail to act in the face of a known duty to act, thereby demonstrating a conscious disregard for their responsibilities, they breach their duty of loyalty by failing to discharge that fiduciary obligation in good faith. Stone v. Ritter, 911 A.2d 362 (Del. 2006).
Duty of Loyalty (Good faith) Legal Tests. Duty of loyalty requires a director to demonstrate thatactions taken were in goodfaith and in best interests of the company. Courts must be convinced that decisions taken were not with a wrong intent or purpose, and hence not in badfaith . The test of purpose behind a decision is used as a measure. To act in good faith, a director must act at all times with an honesty of purpose and in the best interests and welfare of the corporation. In re Walt Disney Co. Derivative Litigation 906 A.2d 27, 53 (Del. Ch. 2006). A director owes a duty to the company to act in what she/he honestly considers to be the interests of the company. Madoff Securities v. Stephen Raven [2013] EWHC 3147 (Comm). A director would not be held to have failed in fiduciary duty if they act in good faith in what they believe, on reasonable grounds, to be the interests of the company. Needle Industries (India) Ltd. and Others Vs. Needle Industries Newey (India) Holding Ltd. and Others [(1981) 3 SCC 333] Honesty in purpose is key to establishing good faith. Demonstrating good faith depends on facts and circumstances, which must be backed by evidence.
Duty towards Shareholders Duty of loyalty, as established in US, has a duty of disclosure towards the shareholders. Directors are obligated to disclose all material information when soliciting shareholder action. The duty of disclosure is an application of both the duties of care and loyalty. Pfeffer v. Redstone, 965 A.2d 676, 684 (Del. 2009). Duty to the shareholders include a duty to make a full and honest disclosure to the shareholders regarding all matters relating to the company. Dale And Carrington Invt. P. Ltd. vs P.K. Prathapan and Ors. (2004).The requirement flows from a director s duty to act in good faith and make full disclosure to the shareholders regarding affairs of a company. Dale And Carrington Invt. P. Ltd. vs P.K. Prathapan and Ors. The duty of disclosure is significant in the case of listed companies.
Demonstrating Good Faith Setting of Board processes- timing, evidence, recording, preserving protocols Setting the tone for the company and the standards of conduct Establishing oversight responsibilities that operate independently Oversight of controls, risks, information, processes etc. Address deviations and demonstrate corrective actions Establish principles of fair play and fair pricing especially with related party or with parties having any significant influence Disclose effectively and have err on more than less
Accountability for Independent Directors Independent Directors are legally accountable only in respect of such acts of omission or commission by a company which occurred with their knowledge, attributable through board processes, and with consent or connivance, or where he had not acted diligently. [Section 149(12), CA2013]. This is equivalent of the business judgment rule, as prevalent in the United States, where courts have held the court will not second-guess a board s decision if it: 1. followed reasonable process 2. took into account key relevant facts 3. Is made in good faith - goodfaith requires that the board act without conflicts of interest and not turn a blind eye to issues for which is it responsible.
BJR Tests of Good Faith and Fairness The concept of Business Judgment Rule ,as embodied in the safe harbor provisions for independent directors under Indian laws, is yet to be tested in Indian courts. As held by the Delaware court in Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984)to avail immunity under BJR: directors have a duty to inform themselves of all material information reasonably available to them. the decision must have been taken in good faith informed business decisions. The presumption of good faith and fairness, may be rebutted, if it is shown that a director had a personal financial interest in a transaction (i.e. lacked independence) did not inform her/himself of all information that was reasonably available, failed to exercise the requisite level of care, or stood on both sides of the transaction; the director must satisfy the stricter standard of entirefairness .
Board Process Explained According to a circular of the Ministry of Corporate Affairs issued in 2011, board process includes meeting of any committee of the Board, and any information which the director is authorized to receive as director of the Board as per the decision of the Board. They include formal channels of communication such as circulars, agenda, resolutions, etc. made available to Board members. In determining whether a director had acted in accordance with law, prosecuting agencies would examine Board minutes of the company to arrive at a conclusion as to whether the Independent Director is responsible for any violation of law. Minutes that detail a board s deliberations serve to bolster the defense against a claimed breach of the director s duty of care.
Invoking safe harbour provisions Was not aware of essential facts and circumstances leading to the illegal decision, but had through legitimate means (attributable through Board process) tried to access information regarding the same. When can an ID invoke safe harbor provisions seeking immunity from wrongful acts of omission or commission Did not give consent to the decision or had not connived. This must be supported through dissenting views recorded in board minutes, in case the ID was aware of the decision being taken. Section 149(12), CA 2013 Had acted in due diligence. (in which case an ID must demonstrate that he had acted with due diligence).
Liability for Independent Directors Independent directors function with a common goal of achieving higher standards of corporate governance, by working as a collective team. In terms of determining liability, however, every independent director is personally accountable towards due discharge of her/his responsibilities. The liability for violation of laws is contingent upon two tests o Substantive Assessment: Whether an Independent Director is at default, by active association?[Definition of officer in default -Section 2(60), CA2013] o Demonstrative Assessment: If an Independent Director has effectively discharged her/his duties essentially a test of diligence and good faith?. The substantive liability would weigh upon an ID if was party to the default, or was in knowledge of its occurrence (gained in accordance with board process), or had consented/ connived in its decision making process.
Liability for Independent Directors contd. Officer who is in default [Section 2(60), C2013] includes any person on whose advice, directions, or instructions the Board of Directors of the company is accustomed to acting. It also includes every director who is aware of a contravention by virtue of the receipt by her/him of any proceedings of the Board or participation in such proceedings without objecting to the same, or where such contravention had taken place with her/his consent or connivance. The liability on an ID will be deemed established if as a member of a Board Committee (Audit, Nomination & Remuneration Committee, CSR, etc.) they provide to the Board of Directors, advice/ recommendation with respect to an action which is illegal. The liability can even arise when an ID is aware of an illegality, in which case it needs to be established if the ID was aware of the contravention taking place. Breach of company law generally entails civil and criminal liabilities under a number of sections including punitive action under section 447, CA 2013 (defining fraud) which provides for imprisonment from 6 months to 10 years and a fine up to the amount of fraud to a maximum of three times the amount under question for fraud or false disclosure in any returns, report, financial statement, or prospectus.
Mitigating Liability for IDs The liability provisions under the scope of officer of default [Section 2(60), CA 2013] can be mitigated if the ID can satisfy the courts that decision was taken with due diligence and good faith in action. Based on the business judgment rule, immunity safeguard, as applicable in India, courts are unlikely to doubt the credence of an Independent Director is she/he has discharged responsibilities by: application of an independent mind, recorded in Board deliberations and evidenced through properly maintained minutes applying knowledge as expected of her/him, a test of prudence of an ordinary person with an equivalent level of knowledge/ expertise acting on an informed basis, (availed of sufficient and credible information, as provided through legitimately accessed Board documents). not being party to the commission of the offence.
Independent Directors Primary Functions Independent Directors is categorized broadly into as: Advisory: consult with management regarding strategic and operational direction of the company. Oversight: monitor management actions to ensure they act in sync with company objectives and policies. Advisory functions by Independent Directors covers issues of strategy, performance, risk appointments and standards of conduct. management, resources, key Oversight functions include scrutiny of management performance, monitor reporting of performance and providing objective opinion in the evaluation of the performance of the board and the management.
Areas of Intervention for IDs Role of independent directors includes the following, categorised into : Strategy. Constructively challenge and help bring an independent judgement on Board s deliberations on issues of strategy. Performance. Review the performance of management in meeting objectives and monitor the reporting of performance. Bring an objective view in the evaluation of performance of Board and management. Financial Reporting, Internal Controls and Risk. Ensure the integrity of financial information and the adequacy of financial controls and systems risk management. People. Bring independent judgement with respect to Board s deliberations on key appointments and standards of conduct. Determining remuneration of executive directors in management succession planning and in appointing and where, necessary, recommend removal of executive directors, KMPs, senior management.
Responsibility towards Stakeholders Under section 166 of CA2013, directors are required to take actions in the best interests of the company, its employees, shareholders, and towards protection of the environment. Independent Directors are additionally required to safeguard the interests of all stakeholders, particularly the minority shareholders. (Schedule IV, CA 2013). Stakeholders not defined under the law. Hence, responsibility lies towards all who face a direct or indirect impact due to a company s operations. Role of IDs towards safeguarding stakeholders interest entails them to ensure that concerns of the minority shareholders or other stakeholders are not curbed and not left unaddressed.
Managing Stakeholders Conflict Independent Directors required to resolve stakeholder conflicts. Balancing conflicting interests of all stakeholders is difficult and may need strategic prioritisation based on circumstances of a particular situation and assessment of the medium to long-term impact of a decision. Discussions and deliberations are the keys to achieve such a balance. Pursuing the long-term interests of the company on a sustained basis could address the potential conflict areas between one group of shareholders and others. Stakeholder value creation is important in dealing with concerns over conflicts between stakeholders. Independent Directors all through must ensure a balanced treatment of all stakeholders, and convince the management to pursue policies that blends a harmonious relationship among all stakeholders.
Independent Directors in Board Committees
Board Committees and Independent Directors Board Committees Board Committees are carved out among existing Board members, based on the degree of expertise. Independent directors form an essential part of Committees, for their specialized subject-matter knowledge and relevant industry experience, and for imbuing independent thinking. Board Committees function independently but are required to bring their recommendations on key issues before the full board for approval. Board Committees share greater responsibility as they are primarily in knowledge of facts and circumstances leading to the decisions taken. Rights and Privileges Committees have operational freedom, subject to areas defined in their Charter. They are entitled to hire, at company s cost, services of experts, as felt required to meet their standards of duty. Board Committees function under powers delegated by the Board. Board Committees look into operational aspects of matters under consideration, and base their judgement accordingly. The role of Committee s goes into fact-finding and analysis of a subject under consideration. Audit Committee s cannot plead ignorance of missing out on essential facts leading to a decision. The onus of correctness of a decision lies with the Committee and members who form part of it.
Role as an Expert Role of Independent Directors is not generalist in nature. They are specialists in their respective fields. Under CA2013, Finance, law, management, sales, marketing, administration, research, operations, or disciplines related to company s business have been listed out as fields of study for Independent Directors. The level of expertise expected of an ID vary according to the committee they are associated with. For instance, Audit Committee members must have ability to read and understand financial statements. [Proviso to Section 177(2), CA2013]. While the law recognizes the technical competence, expertise and experience of an ID, this recognition is subject to enabling factors, like, whether she/he was coerced into a decision, or whether all data/ information leading to the decision were available. So long, an independent director establishes that the decision taken was prudent, reasoned/ justified (based on available facts) and was taken with due regard to existing tests of due care, diligence and good faith, an Independent Director can claim recourse under the Business Judgement immunity. corporate governance, technical
Expertise of an ID Does being a specialist or an expert in a committee create a greater risk for Independent Director? In the US, in a case relating to a class action suit, in Tischler v. Baltimore Bankcorp801 F. Supp. 1493 (D. Maryland 1992), it was held that the overall responsibility for supervising the management of Bancorp and verifying the assets, collateral, loan values, and determination of appropriate loan-loss reserves and write-downs of non-performing loans and assets, was limited to Independent Directors alone, because of their specialized knowledge and expertise. The court, while allowed the motion against those directors who were experts and sat in the Audit Committee, and disallowed the motion against others who did not have such expertise. Similar position exists in India, as Sebi in its orders have disallowed ID s from taking a defence over lack of understanding of financial statements resulting into errors. Independent Directors, particularly those sitting in Audit Committees, must fulfil the higher standards of accountability commensurate to their expertise and experience.
Expertise of an ID ...contd. In Pyramid Saimira Case, Independent Directors overlooked several red flags in the trends in revenues, profits, receivables, advances, etc., which enabled the company to inflate its revenues and profits by fictitious entries in its accounts, and failed to disclose these in quarterly and annual accounts of the company. SEBI, in its order, noted that such aberrations in financial numbers could not be missed by an Independent Directors in the normal course, as was argued. Such gaps would alert a man of ordinary prudence, and an independent director who is part of Audit Committee, . IDs, sitting on Audit Committee or any other committees with respect to matters of financial statements, accounting, internal controls, etc , face a higher risk of liability by their expert role. Similarly, ID s fulfilling an expert role in any other committee or process, would have similar liabilities.
Thank you Thought Arbitrage Research Institute C 16, Qutab Institutional Area New Delhi - 110016
