INDEPENDENT DIRECTORS AND THEIR ROLE IN CORPORATE

GOVERNANCE

Author: Abhishek Gupta

Co Author: Shah Rukh Ahmad

1.0 INTRODUCTION

1.1 BOARD AS THE HEAD OF CORPORATE ORGANIC STRUCTURE

As an artificial person (company) it functions through human

agencies. Human intervention is required either in the stage

of policy formulation and implementation of the said policy.

So, the question arises: who will act on behalf of the

company? Obvious possible answer is the ‘board of directors’.

Historically, the ‘board of directors’ in present company had

its legacy from the ‘board of trustees’ of ‘deed of settlement

company’ and ‘board of governor’ wherein day to day business

of company has been entrusted with ‘board of trustees’.1

The Board of directors in present corporate structure is the

principle organ. If we consider corporate structure with human

bodies’ then possibly the board of directors is head of that

organic structure. The management of that company is vested in

the board of directors and for powers expecting those which

are especially reserved with the general meeting by the Act or

the articles of association or otherwise must be done by the

board of directors. So, the power of board is equal to power

of the company. The directors of the company constitute the

board collectively. The power are, however, conferred on the

1See Devis Paul L, Gower’s Principles Of Modern Company Law, Sweet & Maxwell, sixteenth edn, 1997 , pp 29-30.

board collectively and not on the individual directors. And

the directors as a general rule act collectively in the board

meeting. The company is entitled to the benefits of collective

wisdom of board of directors. However, the board may pass a

resolution by circulation, provided the resolution in draft

has been circulated with the necessary papers to all the

directors and all members of the committee in India and has

been approved by the directors or the majority of them. To

constitute a valid meeting of board of directors, it is

necessary that the notice of the meetings shall be given in

writing to every director for the time being in India and that

a quorum being present. Certain powers of the board of

directors can only be exercised by the resolution passed at

meeting of the board, namely power to make calls, power to

issue debentures, power to invest funds of the company, to

make loans. Board of directors of a public company or a

private company which is subsidiary of a public company

cannot, except with the consent of such company in a general

meeting, exercise the power to sell, lease or dispose of the

whole or substantively the whole of the undertaking of the

company, remit or give time for repayment of debt by a

director, invest otherwise than in trust securities, etc,

borrow money in excess of aggregate paid-up capital and free

reserves etc. So, the structure of the board of directors and

the meetings of board of directors are of ceremonial

importance in the proper functioning of the companies. The

general authority of the directors as board members extends to

all acts reasonably necessary for the management. However, the

company is not bound by the acts done by the directors for

objects which it has no power to entertain, these are the only

acts which, if done by the directors, ipso facto void.

1.2 POWER OF THE BOARD AND THE RULE OF LAW

It is clear from above annotation that the activities of board

related to company not only have an impact over people

connected with the company, but it also leaves its impact on

the day to day life of the people one or other way. So, in

present corporatised world, a board is required to be more

responsible and accountable for its action. Legally, ‘rule of

law’ means adoption of the governance in a just, fair and

accountable manner. One would have to appreciate the fact that

there is a difference between the governance and governing.

Possibly the governance is the science of governing, wherein,

the person who is governing is subjected to periodical review

by those to whom he is governing and he should always act for

the benefit and the satisfaction of them. It is to be

remembered very clearly that power and responsibility is

entrusted on them not to be used for personal benefit and

whims and fancies, but to achieve the greater goal for which

the organisation is setup. To achieve this goal, OECD has

proposed certain criteria regarding the functioning of board

in ‘principles of corporate governance’.2

2 http://www.oecd.org/corporate/oecdprinciplesofcorporategovernance.htm

A. Board members should act on a fully informed basis, in a

good faith, with due diligence and care, and in the best

interest of the company and the shareholders.

B. Where board decisions may affect different shareholder

groups differently, the board should treat all

shareholders fairly.

C. The board should ensure compliance with applicable law

and take into account the interest of stakeholders.3

2.0 INDEPENDENT DIRECTOR AND ROLE: WHO IS THE INDEPENDENT DIRECTOR?

Independent directors as generally understood are those who

apart from receiving remuneration have no material interest in

a company. Expert committees on corporate governance all over

the globe suggested the appointment for independent directors’

in the board in present corporate structure.4 Reason for

appointment of independent director on the board is to

strengthen the internal control in absence of effective

shareholder control.5 Attempt has been made to give the

definition or meaning of independent director. Intestinally,

these definitions or meaning of independent director is based

on the cultural and economic aspect of respective country,3 OECD Principles of Corporate Governance, 2004, Preamble and Article IV4In present times, publicly held listed company has very wide base of shareholders. Sometime it crosses the boundary of the state of incorporation.5See Berle, Adlof A & Means, Gardiner C, The Modern Corporation and PrivateProperty, The Macmillan Company, 1962, ch 1, ‘Property in Transitions’, pp 1-9.

developed upon the experience particular to the respective

legal system. However, there are also certain communalities in

this problem.6

2.1 How to define independent director?

According to NASDAQ "Independent director" means a person other

than an executive officer or employee of the company or any

other individual having a relationship which, in the opinion

of the issuer's board of directors would interfere with the

exercise of independent judgment in carrying out the

responsibilities of a director.7

According to the indicative definition by the International

Finance Corporation (‘IFC’), independent directors must fulfil

certain prescribed minimum requirements. The standard which is

sought to be established attempts to ensure the integrity of

decision making; unhampered by circumstances extraneous to the

interests of the company, i.e. they reduce the scope of

interference by such circumstances.8Others looked it as

directors ‘who apart from receiving directors’ remuneration do not have

any other material pecuniary relationship or transactions with

the company, its promoters, its management or its

subsidiaries, which in the judgement of the board may affect

6In the functional aspect of the company.7 NASDAQ Rule 4200 a(15)8 See IFC, “Indicative Independent Director Definition International Finance Corporation”, available at http://www.ifc.org/ifcext/corporategovernance.nsf/AttachmentsByTitle/Independent+Director+Definition.doc/$FILE/Independent+Director+Definition.doc as accessed on 17 March 2014.

their independence of judgement’.9 Furthermore, definition of

independent director should be ‘sufficiently broad and

flexible’ so that it does not ‘become a constraint in the

choice of independent directors on the boards of companies’.

Most of the committees in the different countries have agreed

that the following criteria is required to be satisfied in

determining the independent character of a director. According

to them independent director means and includes:

An independent director of the company is a non-executive

director,10 who

(a) Apart from receiving the director remuneration, does

not have any material pecuniary relationships or

transaction with the company, promoter, senior management

9See report of Committee Appointed by SEBI on Corporate Governance, Kumar Mangalam Birla Committee, (Academic Foundation), p 13.10See, Report of the Committee on Corporate Audit and Governance, Naresh Chandra Committee; Corporate Governance Rule Proposal, Reflecting Recommendation from NYSE Corporate Accountability and Listing Standards Committee as approved by the NYSE board of director, 1 August 2002:‘Independent directors do not invariably share a single set of qualitiesthat are not shared by non-independent directors. Consequently, no clearrule can unerringly describe and distinguish independent directors.However, members of the Council of Institutional Investors believe that thepromulgation of a narrow drawn definition of an independent director(coupled with a policy specifying that at least two-third of board membersshould meet this standard) is in the corporation’s and all shareholders’ongoing financial interest because:

- Independence is critical to a properly functioning board,- Certain clearly definable relationships pose a threat to a directors’

unqualified independence in a sufficient number of cases that theywarrant advance identification,

- The effect of a conflict of interest on an individual director islikely to be almost impossible to detect, either by shareholders orother board members, and,

- While an across-the-board application of any definition to a largenumber of people will inevitably miscategorize a few of them, thisrisk is sufficiently small that is far outweighed by the significantbenefits.’

or its holding in a company, its subsidiaries and

companies; company should disclose these determinations.

(b) Is not related to promoters or management at board

level, or one level below board which fall within the

meaning of near relationship.11

(c) Has not been an executive of the company in last

five12 years.

(d) Is not a partner or an executive of the statutory

auditing firm, the internal audit firm that is associated

with the company, and has not been a partner or an

executive of any such firm for the last three years.13

This will also apply to legal firm(s) that have a

material association with the company.

(e) Is not a significant supplier, vendor or customer of

the company.14

(f) Is not the substantial shareholder of the company.

(g) Has not been a director, independent or otherwise,

of the company for more than three terms of three years

each.

(h) Having sufficient knowledge and expertise in the

area where the business operates.

11Different committees have defined the ‘near relationship’ in very boardterms. It includes blood relationship, friends, employer and employeerelationship etc.12 Some of the committees like Naresh Chandra Committee on CorporateGovernance in India, recommended this term for three years.13This time varied has varied with different committees from three years tofive years.14See ‘Financial aspect of Corporate Governance’, Adrian Cadbury Committee,1 December 1992, para 4.10 to 4.17.

It seems pertinent at this point to differentiate between non-

executive directors and independent directors.15 The former

constitutes all those directors that do not belong to the

management of the company, whereas the latter would mean only

those directors who are not only non-executive in nature.

According to the Guidelines of the Commonwealth Association

for Corporate Governance (1999) ‘independence is likely to be assumed

when the director does not have an actual or potential conflict of interest’.

2.2 APPOINTMENT OF AN INDEPENDENT DIRECTOR

Selection process of the board of the directors varies across

companies within the prescribed legal framework of that

company. In some of the companies, the chief executive officer

controls the process, finding and presenting candidates to the

board. In other situations, small groups of directors control

the selection process. In either case, the process maybe

formal or informal. The size of the board of the company is

determined by the by laws or the articles of the association

of that company. Sometimes the statues also prescribe the

lower and the upper limits for the number of board members.

15Corporate governance rule Proposal, Reflecting recommendation from NYSEcorporate accountability and listing standards committee as approved by theNYSE board of director’, 1 August 2002, p 27.

3.0 ROLE OF THE INDEPENDENT DIRECTOR IN GOOD GOVERNANCE

Why to appoint independent director in the board is the

crucial question in the present day debate on corporate

governance. Corporate governance reformers generally presume

that:

(1) Outside independent boards are better than non-independent

boards; and

(2) The more independent a board is, the better it is in

bringing efficiency within the company.

‘In the modern public corporation, shareholders essentially

have no power to initiate corporate action and, moreover, are

entitled to vote on only a few corporate actions. Rather,

formal decision making power resides mainly in the board of

directors. As a practical matter, of course, the vast majority

of corporate decisions are made by senior executives acting

alone. In a capitalist economy, there are two basic ways in

which economic activity takes place: market transactions

between independent actors and transactions within firms.

3.1 Centralised Decision:

Centralised decisions making is thus essential to the

corporation’s function. The remaining problem is to identify

the appropriate decision maker. If management were perfectly

faithful to shareholder interests, the benefits of centralised

management would be maximised if the board were comprised

solely of officers of the firm. Indeed, assuming perfect

fidelity, a hierarchy capped by a single full-time,

professional manager probably would be the ideal decision

making structure.16

3.2 Reluctant effort’s by Shareholders

Shareholders also have insufficient incentives to gather the

information necessary to be actively involved in running the

corporation. A rational shareholder will expend efforts to

make an informed decision only if the expected benefits of

doing so outweigh its cost. Given the length and complexity of

studying corporate disclosure documents, the opportunity cost

entailed in making informed decisions is both high and

apparent. In contrast, the expected benefits of becoming

informed are quite low, as most shareholders’ holdings are too

small to have a significant effect on the vote’s outcome.

Shareholders are thus rationally apathetic to either gather

the information or even to act on that information.17

3.3 Maintain Hierarchy

Under conditions of different interests and unequal

information, hierarchical decisions making structures are

16Brainbridge, Stephen M, ‘Independent Director and the Ali Corporate Governance Project’, George Washington Law Review, vol 61, p 1034.17 In other words, in making interference in the functions of management.

essential for organizational efficiency. In a sense,

management is simply information processing. For effective

management, those with the power to make decisions must have

the necessary information, which must not be distorted by

others’ subjective interpretations. At the same time, however,

managers must not be overloaded with unnecessary, distracting

information. Branching hierarchies put people into small

groups, each member of which reports information to the same

supervisor.

The corporate management runs in a hierarchical structure. For

example, the command of implementation of project comes from

the CEO of a company and the people who are in different

strata of the management implements it. The democratic

functioning of corporate management becomes almost absent

where the chairman of the board is a promoter-chairman or

powerful CEO who always had his way by dictating the terms of

the way in which the corporate should function. This is also

associated with the vested interest of functionaries in board

so the contrary opinion is never voiced. It is presumed that

the independent director will act as a strong buffer and will

make the management accountable to the board for the actions

they have taken. They also act as a watchdog vis-à-vis the

affairs of the company wherein the company is exposed to

potential risks. They inject an independent and critical

thinking in the functioning of a corporate. So, the status and

externality had an impact over the proper functioning of the

company as well as for the good governance of the company

3.4 Proper Functioning

A common belief amongst legal systems is that an independent

director helps in proper functioning of the corporate, because

of the fact, they do not have a material interest in the

company and they will really represent the interest of all the

investors and small shareholders. Presumption lies on the

issues that executive or promoter director are interested in

making the wealth for themselves and not interested in the

well-being of all the stakeholders and they are not perfectly

faithful.18 Accordingly, corporate law steps in to provide

alternative monitoring mechanisms. Chief among them is the

board of directors, especially the independent directors.

In many of the cases it is evident that CEO of a company hides

the real picture of the company from the potential investor

and its stakeholders. So, the person who is knowledgeable in

the similar kind of business, who does not possess any

relation with internal management of company will act

independently for benefit of its shareholder and stakeholders.

18See, Brainbridge, Stephen, ‘Independent Director and the Ali Corporate Governance Project’, George Washington Law Review, vol 61, p 1034.

4.0 CONTROVERSY OF THE INDEPENDENCE OF THE INDEPENDENT DIRECTOR

In some cases, the founder of business may still be inactive

in management after a long tenure and even CEO or the chairman

of the board. In these cases the dominant chairman or CEO is

apt to influence or control the process. When the CEO is in

the control of nomination process he or she has the tendency

to seek individuals who are personal acquaintances of friends

and who are likely to be supportive of the CEO. The result can

be an apparently independent majority that in practice, takes

its cues from management and functions much like a group of

insiders. Consequently, the establishment of a genuinely

objective process is crucial for corporate board.19

19See Colley, John, What is Corporate Governance, 2000, McGrew-Hill Companies, pp 23-24.

A truly representative process would have the shareholders

nominating and electing individuals to represent them. For a

number of reasons, however, this process is not practical.

First, many shareholders do not behave like long-term

investors; indeed, they are essentially traders, who move in

and out of stocks and are not particularly interested in

participating in the governance of corporations in which they

own stocks. Institutional shareholders (including mutual

funds, pension funds, and insurance or mutual companies)

generally do not want to be directly represented on the board

of companies in which they invest because this would make them

insiders, which, in turn, would limit their flexibility in

deciding whether to buy or sell. Finally, the board group of

small, public shareholders is not a cohesive body that is

organised to act together. In theory, they could identify and

nominate directors, but they seldom do. This leaves the

nomination process to either the existing board, which may be

inclined to perpetuate itself, or to major shareholders to

nominate their representatives. When a group of shareholders

becomes disenchanted with management, they may nominate a

slate of directors and engage in a proxy battle. Consequently,

the nominating process for directors is usually managed by

controlling shareholders and/or the current board through its

nominating committee.

The question of independency of an independent director gets

difficult in a publicly held corporate structure. Most of the

annual reports of the company do not ascertain the background

of the independent director, on the contrary they designate

some of them as independent directors.

Even so, in some corners of academia, debate about the value

of independent directors persists. Empirical studies have

shown that a majority independent board does not improve firm

performance, ie, firms with a majority of independent

directors do not perform better for shareholders than those

with a minority of independents.20

There is no solid evidence suggesting that independent

directors improve corporate performance. Some studies have

even found a negative correlation between board independence

and corporate performance.

A recent comprehensive…reviews other studies along with…research and finds,

among other things, that there is no evidence that greater board independence

leads to better firm performance. Poor performance is correlated with subsequent

greater independence, but there is no evidence that this strategy works to improve

performance. While independent directors with significant stock positions may add

value, others do not.21

5.0 COMPENSATION OF THE INDEPENDENT DIRECTOR

Compensation to independent director is an important issue in

corporate governance. It is the general belief that

independent directors bring value addition to the board

through their skill, expertise and efficiency. The presumption

20Rodrigues, Usha, ‘The Fetishization of Independence’, Journal of CorporateLaw, vol 33, p 447.21 Clarke, Donald C, ‘Three Concepts of Independent Director’, vol 32, Delware Journal of Corporate Law, p 73.

is that the person designated as the independent director in

the board must be a person of efficiency and high credential.

It is important that the person should spend quality time in

the affairs of the company. Naturally, adequate compensation

is required to be paid to the independent director. Different

committees on corporate governance have suggested mechanisms

to devise adequate compensation for the independent director.

Further, independent director should not be involved in any

material gain because of the position.

6.0 INDEPENDENT DIRECTORS OVERVIEW BY COMPANIES ACT 2013

The need for the Independent Directors aroused due to the need

of a strong framework of corporate governance in the

functioning of the company. There is a "growing importance" of

their role and responsibility. The Act, 2013 makes the role of

Independent Directors very different from that of executive

directors. An Independent Director is vested with a variety of

roles, duties and liabilities for good corporate governance.

He helps a company to protect the interest of minority

shareholders and ensures that the board does not favour any

particular set of shareholders or stakeholders.

The role they play in a company broadly includes improving

corporate credibility, governance standards, and the risk

management of the company.22

6.1 CURRENT POSITION UNDER THE STATUTE:

The Act, 2013 has adopted many of the provisions of clause 49

of the listing agreement and has defined the term 'Independent

Director' u/s 2(47) which says that 'Independent Director'

means an Independent Director as referred to in sub-section

(5) of section 149. The new Act along with the definition of

Independent Director also provides the criteria for

appointing, qualifications, tenure, remuneration and liability

of Independent Director.

As per sub-section 6 of Section 149 of the Act, Independent

Director means a director other than a managing director or

whole time director or a nominee director.23

22 See, AZB patners, Independent Directors under act 2013 http://www.assocham.org/events/recent/event_917/Gautam-Saha.pdf accessed on20 march 2014.23 a) Who, in the opinion of the Board, is a person of integrity and possesses relevant expertise and experience;b) 1. Who is or was not a promoter of the company,2. Who is not related to promoters or directors in the company.c) Who has or had no pecuniary relationship with the companyd) None of whose relative has or had pecuniary relationship or transaction with the company.e) Who, neither himself nor any of his relative---i. Holds or has held the position of a key managerial personnelii. Is or has been an employee or proprietor or a partner, in any of the three financial years proceeding.iii. Holds together with his relative two per cent or more of the total voting power of the company; oriv. Is a Chief Executive or director, of any nonprofit organization, or who possesses such other qualifications as may be prescribed.

6.2 ROLE AND DUTIES OF INDEPENDENT DIRECTORS

The role of an Independent Director is considered to be of a

great significance. The guidelines, role and functions and

duties and etc., are broadly set out in a code described in

Schedule IV of the Act, 2013. The code lays down certain

critical functions like safeguarding the interest of all

stakeholders, particularly the minority holders, harmonizing

the conflicting interest of the stakeholders, analysing the

performance of management, mediating in situations like

conflict between management and the shareholder's interest

etc.

The code also lays down certain important duties like keeping

themselves updated about the company and the external

environment in which it operates, not disclosing important and

confidential information of the company unless approved by the

board or required by law, actively participating in committees

of the board in which they are chairperson or members, keeping

themselves update and undertaking appropriate induction and

refreshing their knowledge, skills and familiarity with the

company, regularly attend the general meetings of the company

and etc.

6.3 MEETINGS & COMMITTEES

The Act, 2013, requires all the Independent Director to meet

at-least once in a year. The meeting must be convened without

the presence of the non-independent directors and members of

the management. An Independent Director would also evaluate

the performance of the chairperson of the company. Also, the

Act, 2013 requires an Independent Director to review the

performance of the non-independent directors and the Board as

a whole of the company. These measures would immensely aid in

ensuring the smooth and proper functioning of the Board of

Directors of a company.24

6.4 LIABILITY

The Act, 2013, has sought to balance the wide nature of the

obligations, functions and duties imposed on an Independent

Director.25 The Act, 2013, restricts and limits the liability

of Independent Director to the matters which are directly

relatable to them. Section 149 (12) limits the liability of an

Independent Director “only in respect of acts of omission or commission by a

company which had occurred with his knowledge, attributable through board

processes, and with his consent or connivance or where he had not acted diligently”.

7.0 INDEPENDENT DIRECTOR A WAY FORWARD: RECOMMENDATIONS

A majority of the independent directors on Indian boards are

retired professionals with a fair proportion of accountants

and legal experts. Furthermore, a closer examination reveals

24 See, Independent Directors under act 2013, http://www.lexology.com/library/detail.aspx?g=45f2cd2e-88a0-46bf-ba56-5b404c2e4681 accessed 20 march 2014 25 See, Roles & Responsibilities of an Independent Director under Companies Act 2013, http://corporatelawreporter.com/2013/11/14/roles-responsibilities-independent-director-companies-act-2013-conference/#ixzz2wWfn48fy, accessed on 20 march 2014.

that there is a small group of people who hold five or more

directorships. So the need of an hour is that:

The independent directors are expected to play the role

of whistle-blowers on the board. And what is really

required is a diverse group of individuals who can

examine issues from diverse perspectives and add value to

overall performance rather than merely examining issues

from compliance angle.

There is a perception that a company with illustrious

names on its board is better governed. But having these

names on the board does not guarantee better standards of

corporate governance.

There is a need to adopt a more professional, independent

and transparent approach to appointing independent

directors. It is important for companies to align their

strategic priorities to skills required in the board room

and accordingly seek candidates for non-executive

positions on the board.

One practice that Indian companies need to take up is to

have senior management executives in large diversified

groups, other than CEOs/ MDs / promoters, taking up non-

executive positions in other company boards.

In recent times, the idea of having a panel of

independent directors maintained by an independent body

has been mooted. However, there is no certainty that

nominating an independent director from such a panel will

result in better governance. Ultimately, the decision as

to who should be an independent director on the board is

as much the prerogative of the company and its CEO as

much as it is the responsibility of the board.

CONCLUSION

In the conclusion we like to state that the objectives of

corporate governance cannot, be as effectively met without the

inclusion of independent directors in the larger scheme of

things. This becomes even more convincing in the context of an

escalating Indian economy with unprecedented amounts of funds

flowing into companies from within and outside the country.

The growth of business interest, there is a rise in

expectations that Indian companies would abide by the highest

standards of corporate governance in a manner clearly

demonstrable to the investors. There have been long standing

demands for greater transparency in the functioning of Indian

companies which are now being met with through various

proposals, amongst which a greater role for independent

directors has been a welcome change.

Inclusion of independent directors is a check on the

management of companies as an oversight mechanism. Their

ability to contribute to the board’s deliberations is an added

bonus to voice the minority interests.

Some experts have pointed out several deficiencies in the

working of independent directors. These include complaints

against their inability to find sufficient time and their lack

of knowledge regarding the company affairs to fulfil the

demands of their position.26

The Act, 2013 empowers the independent directors to have a

definite 'say' in the management of a company, which would

thereby immensely strengthen the corporate governance.

However it is also important to keep in mind that good

corporate governance is not just the outcome of appropriate

selection and effective functioning of independent directors.

Every director, whether independent/non independent,

executive/non-executive has a distinct role in the functioning

of the company. It is only when the entire board functions

effectively which results to good corporate governance and

benefit minority as well as majority shareholder in its long

term which maintains a good corporate image in the market.27

26 Jay Lorsch, Professor at Harvard Business School, points out that the problems commonly faced with independent directors do not lie with people who serve on boards but instead the structure of the boards themselves. Thus, the underlying problem is that board members are part-timers who are time pressured and who often lack specific knowledge. See Jay Lorsch & Colin B. Carter, Back to the Drawing Board: Designing Corporate Boards for a Complex World, 2004, Harvard Business Press.27 See, corporate governance, http://www.lexology.com/library/detail.aspx?g=45f2cd2e-88a0-46bf-ba56-5b404c2e4681 accessed on 20 march 2014.