INDEPENDENT DIRECTORS – ARE THEY REALLY INDEPENDENT?

The topic is vey interesting in the present scenario wherein clause 49 of the listing agreement is under scrutiny due to satyam fiasco and other corporate frauds of such magnitude coming into the forefront.

In this article we will not be discussing about the role of independent directors in the audit committee as the same is expected to be dealt in the paper presented on ‘Satyam Case- Failure of Corporate Governance’. Our discussion would be based on the overall act of an individual who is appointed as an independent director of a Company and whether he act in the interest of the promoters or in the interest of the Company and the stakeholders(i.e. whether he acts independently or not).

Discussion can be commenced by stating the definition of independent

director for the ready reference of the readers:

As per Clause 49 of the listing agreement, the expression ‘independent

director’ shall mean a non-executive director of the company who:

1. apart from receiving director’s remuneration, does not have any material pecuniary relationships or transactions with the company, its promoters, its directors, its senior management or its holding company, its subsidiaries and associates which may affect independence of the director;
2. is not related to promoters or persons occupying management positions at the board level or at one level below the board;
3. has not been an executive of the company in the immediately preceding three financial years;
4. is not a partner or an executive or was not partner or an executive during the preceding three years, of any of the following:

a.    the statutory audit firm or the internal audit firm that is associated with the company, and

ii. the legal firm(s) and consulting firm(s) that have a material association with the company.

     e.    is not a material supplier, service provider or customer or a lessor or lessee of the company, which may affect independence of the director;

     f.     is not a substantial shareholder of the company i.e. owning two percent or more of the block of voting shares.

    g.     is not less than 21 years of age

  

Explanation : For the purposes of the above:

a.    Associate shall mean a company which is an “associate” as defined in Accounting Standard (AS) 23, “Accounting for Investments in Associates in Consolidated Financial Statements”, issued by the Institute of Chartered Accountants of India.

b.    “Senior management” shall mean personnel of the company who are members of its core management team excluding Board of Directors. Normally, this would comprise all members of management one level below the executive directors, including all functional heads.

c.    “Relative” shall mean “relative” as defined in section 2(41) and section 6 read with Schedule IA of the Companies Act, 1956.

d.    Nominee directors appointed by an institution which has invested in or lent to the company shall be deemed to be independent directors.

 Explanation:

“Institution’ for this purpose means a public financial institution as defined in Section 4A of the Companies Act, 1956 or a “corresponding new bank” as defined in section 2(d) of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970 or the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1980 [both Acts].”

From the above definition of Independent Directors, we achieve two main points in the context of our topic independent directors - Are they really independent or not. They are:

1.            Independence of Judgment

2.            No Material Pecuniary Relationship

INDEPENDENT DIRECTORS- INDEPENDENCE OF JUDGMENT? A BIG QUESTION MARK

Independent directors, apart from receiving director’s remuneration, does not have any material pecuniary relationships or transactions with the company, its promoters, its directors, its senior management or its holding company, its subsidiaries and associates which may affect independence of the director.

Thus their decisions should be independent of those who have controlling stake in the Company and in the overall interest of the Company and its Stakeholders.

But in reality who appoints these Directors? No doubt that the shareholders appoint the independent director. But if we see the process of selection of the independent director, it is the existing directors who nominate the independent candidates for the post of the independent non-executive director, that too in consultation with the promoters and the shareholders accepts the nomination on the basis of the recommendation of the Board.

Moreover, as we know the majority shareholders(i.e. Promoters) can dictate the composition of the Board. Although all shareholders can vote on the appointment of Directors, the dominance of the majority ensures that their nominees prevail. This undermines the implied objective of clause 49. To be truly 'Independent', a Director cannot be, nor perceived to be, controlled. It is fallacious to expect an 'Independent Director' to exercise his or her mind impartially against the wishes or interest/s of the majority shareholders, when the tenure of his or her office depends on their appointment by the majority shareholders.

If the authorities are serious about practically ensuring a 'strong and independent element on the Board', then the clause 49 should stipulate that the appointment of Independent Directors should be made by an independent party and not by the majority shareholders.

Although it is well accepted that the duty of all directors is to protect the interests of shareholders including minority shareholders, it is the so-called 'Independent Directors' who are entrusted by the minority shareholders to protect their interests. In spite of their appointment by majority shareholders, 'Independent Directors' are expected to pay particular attention to the interests of the minority shareholders. But there are occasions where their interests may be compromised by the expectations of the majority shareholders.

As a guiding principle, independent directors should always act impartially, looking out for the best interest of the company, its shareholders and in particular its minority shareholders. 'Independent Directors' should discharge their duties without fear or favour.

The above clearly suggests us that its possible for persons well known to the directors to get elected to the Board. If that happens(it normally does happen) then it’s the very first juncture at which independence is lost.

Of course, when independent candidates are persons well known in the business or academics circles, additional justification is hardly needed for their appointment.

Thus the bottom line is that the Independence of judgment characteristic of Independent Directors is far from reality.

NO MATERIAL PECUNIARY RELATIONSHIP- APART FROM RECEIVING DIRECTORS REMUNERATION- Whats the reality??

Another interesting angle is the compensating factor. An independent director is compensated for his services by way of sitting fees and commissions. The provisions relating to sitting fees and commission to independent directors are as follows:

l  Sitting Fees [Sec.310] for each meeting of Board or Committee thereof

†  In case of Companies with Paid up Capital and Free Reserves of Rs.10 Crores and above or Turnover of Rs.50 Crores and above - Not to exceed Rs.20,000 per meeting

†  In case of other Companies - Not to exceed Rs.10,000 per meeting.

l  Commission to Non Executive Directors (i.e. including independent directors) [Sec. 309]

†  Not to exceed 1% of Net Profits if the Company has a MD or WTD or a Manager

†  Not to exceed 3% of Net Profits, in any other case

We can see from the above provisions that the sitting fee cannot exceed Rs. 20,000 or Rs. 10,000 as the case may be, for each meeting of the board or committee thereof. No man of repute would lend his time and energy and act as an independent director for sheer sitting fees and take independent decisions for the sake of interest of a Company and its stakeholders.

The very reason of taking up the post of an Independent Director by a man of repute is the Commission which he receives under section 309 of the Companies Act, 1956 as stated above. Where the commission is linked to the Company’s performance, the very objective of prohibiting such directors from accepting a salary is defeated and to some extent thrown in garbage.

Also, the articles of association of most of the Companies mandates that directors have to hold a minimum number of shares in the Company so as to qualify for the directorship and many individuals holding shares of the Company (though less than 2%) also sometimes get appointed as independent director.Once compensation is linked to Company’s profit or share price performance, doesn’t this create a vested interest in ensuring that the Company’s reported numbers are good?? Obviously, the situation of reporting of inflated numbers cannot be denied.

Hence, how can you take for granted that an individual appointed as an independent director would act in favour of the interest of the Company and stakeholders. He would rather focus on increasing the net profits by taking such decisions ( whether ethical or not) which could lead increase in his %age of commission by shaking hands with the promoters neglecting thereby the responsibility towards the Company and the stakeholders

Thus, it can be seen that an independent director is dependent on the Company’s profit as his commission is calculated on the basis of the net profit and on share price performance if he holds good number of  shares of the Company (though less than 2%).

MIXING THE ABOVE TWO MAIN POINTS, WE CAN FURTHER EXPLAIN INDEPENDENCY WITH THE HELP OF THE FACTS AND PROVISIONS STATED BELOW:

As per clause 49 of the listing agreement, the board of directors of the Company shall have an optimum combination of executive and non-executive directors with not less than 50% of the board of directors comprising of non-executive directors. Where the Chairman of the Board is a non-executive director, at least

one-third of the Board should comprise of independent directors and in case he is an executive director, at least half of the Board should comprise of independent directors.

Provided that where the non-executive Chairman is a promoter of the company or is related to any promoter or person occupying management positions at the Board level or at one level below the Board, at least one-half of the Board of the company shall consist of independent directors.

Thus clause 49 says that if a Company has a non-executive chairman, only one-third (and not 50%) of the Board shall consist of independent directors. This concession creates an opportunity for the promoters to take advantage of. In many Companies, promoters have designated known persons as the non-executive chairman to take advantage of one- third independent directors provision as stated above.

A study by the research team of Prime Database, which operates website directorsdatabase.com, a joint initiative with the Bombay Stock Exchange(BSE) have revealed that “Nearly 75% of all independent directors are home members who are natural allies of the promoters are not independent in any sence”.

“Even if the Home members, which include the relatives (other than those specified in the Companies Act, 1956), friends neighbours etc., are qualified they cannot act independently because of their connections with the promoters.” Said the study bases on the profiles of independent directors on the board of 2,244 Companies listed on BSE.

The above measures taken by the promoters are to assure that only those individuals are appointed as independent directors who knocks the head positively to whatever the promoters decides and approves the same.

On another front, while the listing agreements prescribe that anyone related to the promoters cannot be an independent director, it overlooks the relationship among independent directors. If independent directors are related to each other and one of them is totally acting in favour of the promoters then he could influence the others to act in the same way too and thus may set aside the interest of the Company and stakeholders.

On the basis of the above, we can conclude by saying that the Independent directors are not independent as such. They are dependent on the major shareholders (i.e. Promoters) for their appointment, on management for the information given on the position of the Company and on the statutory auditor and internal auditor for the information on financials of the Company. Hence there is no independent method of verification of facts.

Even if one or two of them are independent of there judgment and takes a fair and prudent view, then also at the end of the day the decision of the majority prevails, diluting the effectiveness of their view.

On broader basis, it is generally true that independent directors are hired neither for better corporate governance nor for protecting minority shareholders interests. They are actually hired for compliance of listing agreement.

We can clearly see from the above discussion that Independent directors are not independent. Hence the very word independent is a misnomer. They should be rightly named as dependent directors.

Therefore, we can conclude that independent directors are though appointed in the interest of the Company and the Stakeholders, they end up doing good to the Promoters……………………….