Thursday, May 12, 2011

Independent Directors - Their roles and responsibilities

The Board of Directors of a public listed company comprise mainly of 2 types of Directors. The Executive Directors who are part of the company are concerned with the day to day running of the company and dealing with the every issues which crop up. Independent Directors on the other hand are accomplished persons who are on Board of the Company, who have no relation to the executive Directors. Their main function is to bring in a fresh perspective towards Boardroom strategies and at the same time prevent mismanagement of the Company. As per SEBI regulations, every listed company should have atleast a third of the Board filled with ID’s.

Independent Directors
An ID is a non-executive director on the board of a company who has integrity, sense of accountability, track record of achievements, financial literacy, experience and the independence to balance the interests of various stakeholders, ability to think strategically, degree of commitment, sense of devotion, etc.

The concept is not mentioned in the Companies Act. However, certain administrative functions have been delegated by the Companies Act to SEBI. Hence, as per circular issued by SEBI, clause 49 of listing agreement deals with ID’s(Independent Directors).

Certain requirement are that ID’s should have:
i) no relationships pecuniary or otherwise with any part of company including its directors, associates, subsidiaries, promoters, etc.
ii) no relation to anyone on board of company or a level below.
iii) Not been an executive director of the company for past 3 years.
iv) Not partner of legal or audit firm of the company.
v) Not a material supplier to company.
vi) Not substantial shareholder (i.e 2% or more shares.)

IDs - Their Responsibilities
An Independent Director (ID) is generally a person who is an accomplished professional/manager of social repute. Investors are influenced to invest in such companies seeing the presence of such accomplished persons as IDs on the Board of the company.
Their roles are twofold: First, to monitor the executive management; and the second is to enrich boardroom deliberations, leading to right decisions. While the executive management focuses on the second role, regulators focus on the first role. A reading of the Standing Committee report leads to the inference that the Standing Committee views the failure of Satyam as a failure of independent directors. Many experts subscribe to this view. However, independent directors performed the second role effectively and that is the reason why Satyam could be brought back on rail so fast.

IDs play an important role in challenging and contributing to the development of strategy of the company and to review the performance of the management in meeting agreed goals and objectives. They bring wider experience and a fresh perspective to the Board, while also playing an important role in ensuring financial controls are proper and setting appropriate levels of remuneration for executive directors.

The Companies Bill, 2009, introduces new roles for IDs by clearly defining their functions as well as distinguishing between the role of IDs and Executive Directors.
i) IDs are to receive no remuneration, other than sitting fee or reimbursement of expenses. They can receive profit related commissions or stock options, if approved by Board Members.
ii) The new bill recognizes liability of IDs to the board of the company and provides for a new scheme for penalties and punishment for non-compliance or violation of the law, whereby an ID can also be made liable.
iii) Proposal to set a cap on tenure of ID (6 years). Presumptively to reduce likelihood of IDs getting close to Executive Directors.
Why these Rules would prove beneficial
Investors depend on them to ensure unbiased and proper functioning of the company. Investors are also influenced to invest due to the presence of high stature independent directors present on board of a company. It is under the presumption that independent directors will prevent mismanagement of and ensure efficient management of a company that the public invests in it.

Hence, if there is no mechanism to hold them responsible for not ensuring the same, none of the directors would be interested in the running of the company. These rules would also ensure that the IDs don’t just collect money and sit back. They would be forced into a more proactive role, which would actually justify investor confidence in the company.

It can be argued that, if the above said mechanisms were already in place, a debacle like Satyam may in all probability not have occurred.

Why these Rules could become counterproductive
These rules are basically creating two classes of Directors. It seeks to curtail the enterprise of IDs. Their enterprise contributes substantially towards taking the company forward. These rules could have a policeman effect. That is, the IDs could end up acting as policemen on the Board, scrutinizing and cross questioning each and every strategy, etc, which hamper effective running of the company.

Also, the proposal to deny remuneration to Directors would definitely affect their willingness to be part of the Board, especially since there is also a scheme of penalties and liabilities that are being introduced by the new Bill with the objective of making IDs more responsible for the running of the company. Excessive laws which have the result of levying heavy fines on independent directors for not strictly overseeing affairs of a company would result in the impossibility of getting highly qualified professionals and persons of repute on board a company.

Another proposal is to put a cap of six years on the tenure of an ID. This is essentially to prevent IDs from getting close to the Executive Directors of the company, as this would impair their judgment.

However, it could prove to be counter productive, as the effectiveness of independent directors depends, to a large extent, depends on the confidence of the executive management on independent directors, particularly, in a family-run enterprise. The Indian corporate sector is dominated by family-run businesses. Therefore, a short tenure (six years) of independent directors will be a constraint in developing a relationship of trust between independent directors and the executive management.

Another issue would be when meetings are called at short notice. It would require an independent non – executive director or at least ratification of any decisions by any one ID. This could be difficult to execute, especially when they are not remunerated.

Theoretical ways to ensure responsibility of IDs to company without such strict laws
i) Monetary incentives
ii) Likelihood of loss of hard earned social stature

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