Handling independent directors

Updated: May 20 2014, 03:08am hrs
Independence is a state of mind, so one wonders if it, therefore, can be legislated and then enforced. However, the Companies Act 2013 has just done that. Independent directors are extensively covered under the new company law and it seeks to enforce these provisions on a wide group of companies, including several unlisted public companies. Obviously, something like this is quite likely to be plagued with problems, at least in the initial stages of implementation.

While there has been a requirement to have independent directors under the listing agreement, this is a new concept under the company law. The Act has also brought in several changes in the manner of functioning of these directors. The Act introduces a stricter definition of independence, prohibiting any direct pecuniary relationships, and limits relationships through the directors relatives or his firms or companies. The Act has also codified the duties and responsibilities of the independent directors and sets a code for professional conduct, which makes the role being discussed quite an onerous one. Further, with a view to enhance their independence, it has also introduced, albeit prospectively, mandatory rotation of independent directors, limiting their tenure to a maximum of two terms of up to 5 years each, i.e., a total of up to 10 years. The Act also now mandates unlisted public companies meeting a certain size criteria to have at least 2 independent directors. It also prohibits stock options as a means of remuneration for these directors.

Sebi, while recently amending Clause 49 of the listing agreement, has brought in some further changes, apart from aligning its requirements with the Companies Act. As per the Sebi norms, an independent director who has served for 5 years or more on October 1, 2014, will be eligible for appointment for a further term of 5 years only on completion of his existing term. Further,

Sebi limits the number of independent directorships in listed companies to seven companies and limits it to three listed companies in case the person is serving as a whole time director in any listed company. Further, Sebi also requires an independent director of a listed company to be appointed as a nominee director on material unlisted subsidiaries.

While the intent behind these changes is ensuring better governance, it is fraught with numerous challenges in implementation. For instance, prohibiting all pecuniary relationships (not just material ones) essentially means that if you are an independent director on an airline, you cant fly on any of their flights, or in the case of a bank, you cant have a savings account or in the case of a retail chain, you cant buy anything from any of their stores. Was that the intent when prohibiting any pecuniary relationships The role and functions of these directors includes scrutinising and monitoring the performance of management and also satisfying themselves on the integrity of financial information and that financial controls and the systems of risk management are robust and defensible; now can an independent director, who spends a few hours or days in each quarter, achieve all of this, and is it a reasonable expectation Possibly not, as it make his role almost as onerous as that of an executive director.

On the other hand, with all these increasing responsibilities and associated risks, the remuneration of these directors is set to come down with granting of stock options not allowed any longer, and the remuneration being restricted to sitting fees and profit-linked commissions, which also is capped at 1% of profits for all directors other than managing and whole-time directors. Would this be adequate compensation for all the increased risks and responsibilities that these directors are taking on Again the answer is, possibly not. Further, the rationale for abolishing stock options was to ensure objectivity in the independent directors functioning and that it isnt clouded by impact on stock price performance over a period of time; however, prohibiting stock options and instead permitting profit linked commissions, which is directly impacted by current period profits seems a little counter-intuitive and makes one wonder if the rationale itself is a little flawed.

These changes certainly will result in a demand for more independent directors in both listed and unlisted companies. However, on the other hand, considering the various practical challenges discussed earlier, and other factors such as increased responsibilities, limits on directorships, lower risk appetite, and lower remuneration not commensurate to risks, there will be fewer individuals opting to become or continue as independent directors. This will certainly result in a significant demand-supply mismatch for independent directors, at least in the initial years.

There is a need to more clarity from the corporate affairs ministry in implementing the new requirements on independent directors, especially around the definition of independence and the related practical challenges. The ministry should also consider increasing the thresholds of companies to whom this is applicable and possibly extend the transition time and make this applicable to unlisted public companies in a phased manner. These changes will help alleviate the problems in the initial years.

Sai Venkateshwaran

The author is partner and head, Accounting Advisory

Services, KPMG in India.

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