The recent Satyam scandal and ensuing litigation put the duties of independent directors under scrutiny. The recently enacted Companies Act of 2013 addressed a number of issues relating to the duties and liabilities of independent directors. In the following guest post, Burzin Somandy of Somandy & Associates in Mumbai takes a look at the approach that had been taken under prior law with respect to independent directors’ duties and also at the standards that the Companies Act of 2013 has put in place. As discussed below, the primary purposes of the new Act’s provisions were to ensure transparency and independence.
Many readers will recall that Burzin is the author of the chapter about India in the recently published book, The Global Directors and Officers Desk Book (about which refer here). I would like thank Burzin for his willingness to publish his guest post on this site. I welcome guest post submissions from responsible authors on topics of interest to readers of this blog. Please contact me directly if you would like to submit a guest post. Here is Burzin’s guest post:
The case law that has evolved under the erstwhile Indian Companies Act of 1956 and ancillary legislation which concerns the activities of a company has iterated that the Directors and Officers of a company can be held vicariously liable for the acts of the company, which liability may arise as a consequence of the involvement of the Directors and Officers in the act complained of, the breach of fiduciary duties, negligence or ultra vires acts.
However, the erstwhile Companies Act 1956 did not draw any distinction between a Director and an Independent Director. This concept was first introduced by the Securities and Exchange Board of India in the year 2000 under clause 49 of the Listing Agreement in respect of all companies who wished to list their shares on the stock exchange, whereby the term Independent Director came to be introduced. However, since there was no statutory recognition of this term under the erstwhile Companies Act of 1956, this led to a degree of confusion as to the extent of liability which could be fastened on an independent director wherein proceedings were initiated against the Board of Directors of a company. Post the Satyam scandal and the lawsuit that emanated thereafter, the role of Independent Directors has come under scrutiny, including in a host of judgments that have been pronounced by various courts on the extent of liability which could be fastened on an independent director for acts committed by a company or the remaining directors on the board of a company. However, this raging controversy was ultimately laid to rest in the New Companies Act of 2013, which defines who an Independent Director is thereby providing statutory recognition to the concept of an Independent Director.
The main spotlight of this article is to analyse the evolving concept of the recognition of an Independent Director in listed companies and the emerging trends in their liability exposure, including the sea changes brought about by the new Companies Act of 2013.
Background – Evolution of the concept of an Independent Director :
The severity of Independent Directors was recognized with the prologue of Corporate Governance. The Securities and Exchange Board of India specified the principles of corporate governance and thereby introduced clause 49 in the Listing agreement of the Stock Exchanges which was predominantly formulated for the improvement of corporate governance in all listed companies and which mandates the appoint of Independent Directors in all listed Companies in proportion to the number of directors on the Board of a company.
In spite of the fact that Clause 49 of the Listing Agreement characterizes the concept of an Independent Director, ambiguity persisted until the 2013 Companies Act was enacted, especially in light of the extent of liability of an Independent Director in the event of any contravention of law, as there was no distinction between Directors and Independent Directors in the Companies Act 1956 and since for the most part, it was perceived that Independent Directors were not involved in the day to day affairs and management of a company and were appointed to ensure appropriate corporate governance. Consequently, in legal proceedings filed against the Company and its directors for contravention of law, Independent Directors were faced with the herculean task of establishing their innocence in the acts complained of and that vicarious liability for the commission of an offence could not be attributed to them merely by virtue of their being directors in a company, especially given their lack of involvement in the day to day affairs or management of the company being prosecuted.
This controversy was substantially dealt with in two landmark judgements of the Supreme Court. In the case of K.K. Ahuja v. VK Vora, the Supreme Court observed that to be liable for the commission of an offence, a person should fulfill the legal requirement of being a person in law responsible for conduct of the business of the Company and also fulfill the factual requirement of being a person in charge of the business of the Company. Consequently, the Supreme Court provided a two-pronged test — the first prong being a legal, statute-based test, where it is required to be proven that a person is responsible to the company for the conduct of the business of the company. The second prong is a fact-based test, where through specific averments the complainant has to establish that the particular person was in-fact in overall control of the day-to-day business of the company. Both the prongs need to be complied with. Hence, if a person fails to satisfy the first test, he is not required to meet the second test. Similarly in the case of S.M.S. Pharmaceuticals Ltd. v. Neeta Bhalla and Another, it has been held by the Supreme Court that “The liability arises from being in charge of and responsible for conduct of business of the company at the relevant time when the offence was committed and not on the basis of merely holding a designation or office in a company.
These judgments came as a great relief to independent directors of companies who were facing prosecution alongwith other directors of companies merely by virtue of their being on the board, inconsequential to their involvement in the act complained of.
Looking to the raging controversy on the liability of an independent director in the event of a complaint filed against a company and its directors and specifically post the revelation of the Satyam scam in January 2009 which raised serious doubts about the involvement of independent directors in the day to day working of a company, Independent Directors realised that their role was no longer going to be ceremonial which sparked a demand for better corporate governance. Corporate India during this period witnessed a marked increase in the number of resignations of Independent Directors from the boards of companies. This period saw the issuance of a Circular by the Ministry of Corporate Affairs, which sought to relieve non executive directors against penal action taken against them. This circular provided that directors should not be held liable for any act of omission or commission by the Company or by any officer of the Company which constitutes a breach or violation of any provision of the Companies Act, 1956 and which occurred without their knowledge attributable through the board process and without the consent or connivance of such director or where such director had acted diligently in the board process. The said circular, however, was issued in the context of action being taken by the Registrar of Companies for violation of provisions of the Companies Act 1956 and was not issued generically for all proceedings initiated against directors.
Should Independent Directors be held responsible if they did not smell a rat?
Independent directors are those not charged with the day-to-day affairs and management of the company and are usually involved in ensuring proper norms of corporate governance.
The recent scandals precisely ascertained the growing need for determining the liability of independent directors for prevention and detection of fraud, in view of the limited roles performed by them in the company. Under the 1956 Act and the judgements of the Supreme Court as referred above, an Independent Director can content that he should not be considered as an “officer in default” and consequently is not liable for the actions of the Board. The new Companies Act of 2013 however puts this controversy to rest and provides for the liability of an Independent Director to be limited to acts of omission or commission by a company which occurred with their knowledge, attributable through board processes, and with their consent and connivance or where they have not acted diligently. The said new Act thus saw a sea change and makes a considerable effort to bring the role of an Independent Director in line with the changing needs of corporate governance of India.
Another sea change are the provisions in the Companies Act which deals with the indemnification of a director. As per section 201 of the Companies Act, 1956, a company cannot indemnify a director till such time that she/he is found innocent by a court of law. However, section 197(3) of the Companies Act, 2013 provides that premium paid on an insurance policy shall be treated as part of the remuneration of a director only if such director is found guilty in respect of the violation for which indemnity is sought under a D & O policy. This would therefore mean that directors can now be indemnified and there is no prohibition on indemnification, as was the case with the Companies Act 1956.
Analytical review of Clause 49-Listing Agreement of the Companies Act, 1956 vis-à-vis Companies Act, 2013 :
Clause 49 of the Listing Agreement gives an inclusive definition of Independent Director, covering under its ambit non- executive directors who do not have a material pecuniary relationship with the company, its promoters, management and subsidiaries which may affect the independence of their judgment. Independent directors are those not charged with the day-to-day affairs and management of the company and are usually involved in ensuring proper norms of corporate governance. The Companies Act, 2013, sets to overhaul the provisions relating to Independent Directors and thus gives about a clear demarcation between a nominee director and an Independent Director.
Several other restrictions have also been built into the new act to ensure that there is no financial nexus between an independent director and the company. For instance, the new act prohibits independent directors from receiving stock options of the company. The Listing Agreement does not prohibit the issue of stock options. Rather it provides that the maximum limit on stock options to be granted to independent directors can be decided by a shareholders’ resolution. The new act limits the remuneration of independent directors to sitting fees, reimbursement of expenses for participation in the board and other meetings, and such profit-related commission as may be approved by the shareholders. This is yet another area of inconsistency with the Listing Agreement that will have to be clarified by the regulators.
The primary objective behind the new act’s provisions on independent directors are to ensure transparency and independence. The New Act casts great responsibility on the Independent Directors since it specifies that any decisions taken by the board in the absence of independent directors must be circulated to all directors and can be final only upon receiving ratification from at least one independent director. The Act has thus set high standards on the one hand and on the other ensured that Independent Directors are not privy to legal proceedings when they have no involvement in the act complained of. It is expected that these changes would increase the pool of professionals into the stream of Independent Directors and restore the confidence in such persons to take up board positions knowing that they will not be frivolously prosecuted.