Change in the position of the

Independent Directors for

Corporate Governance.

Article Submission.

Yechuri Naga Sumangali,

Roll no.: 44.

Symbiosis Law School.
LRM Assignment.
Change in the position of the Independent Directors for Corporate Governance.

Introduction1:

An independent board of directors in public listed companies is seen as an integral element of

a country’s corporate governance norms. Board independence has taken on a pivotal status in
corporate governance that it has become almost indispensable. 2 Consequently, governance
reform in recent years has increasingly pinned hope as well as responsibility on independent
directors to enable higher standards of governance. Although the institution of independent
directors has been the subject-matter of debate lately, the concept itself is hardly of recent
vintage. Independent directors were introduced voluntarily as a measure of good governance
in the United States (U.S.) in the 1950s before they were mandated by law. 3 Thereafter,
owing to sustained efforts by the Delaware courts and stock exchanges in deferring to
decisions of independent boards, independent directors took on greater prominence. 4
Following the Enron cohort of scandals, independent directors were recognized by statute as
well.5 A similar, but more recent, trend is ascertainable from the United Kingdom (U.K.) as
well. The requirement for board independence there was triggered by the Cadbury Committee
Report in 1992.6 With these developments, board independence became well-entrenched in
the U.S. and the U.K. The turn of the century witnessed a proliferation of independent
directors beyond the borders of the U.S. and the U.K. to several other countries around the
world. This is due to the profound impact that corporate governance reforms (culminating
with the Sarbanes-Oxley Act in the U.S. and the Cadbury Committee Report in the U.K.)
have had on corporate governance norm-making around the world, particularly in relation to
the appointment of independent directors as an essential matter of good governance. The
Cadbury Committee Report has led the development of corporate governance norms in
various countries such as Canada, Hong Kong, South Africa, Australia, France, Japan,
Malaysia, and India, just to name a few. Similarly, the U.S. requirement of independent
1
[Link]
2
See Donald C. Clarke, Three Concepts of the Independent Director, 32 DEL. J. CORP. L. 73, 73 (2007)
[hereinafter Clarke, Three Concepts] (observing that “[i]ndependent directors have long been viewed as a
solution to many corporate governance problems”). See also Laura Lin, The Effectiveness of Outside Directors
as a Corporate Governance Mechanism: Theories and Evidence, 90 NW. U. L. REV. 898, 899-900 (1996)
(finding that in response to highly publicized allegations of corporate governance problems, reformers have
identified independent outside directors as a possible solution); COLIN B. CARTER & JAY W. LORSCH,
BACK TO THE DRAWING BOARD: DESIGNING CORPORATE BOARDS FOR A COMPLEX WORLD
44 (2004).
3
Jeffrey N. Gordon, The Rise of Independent Directors in the United States, 1950-2005: Of Shareholder Value
and Stock Market Prices, 59 STAN. L. REV. 1465, 1473 [hereinafter Gordon, The Rise of Independent
Directors].
4
Lin, supra note 1, at 904-10 (for a discussion of the reliance placed by the Delaware courts on decisions of
disinterested or independent directors). The New York Stock Exchange (NYSE) and Nasdaq Stock Exchange
(NASDAQ) have emphasized the importance of independent directors on boards of listed companies. See
NYSE, LISTED COMPANY MANUAL (2003) [hereinafter NYSE LISTED COMPANY MANUAL],
available at [Link] NASDAQ STOCK MARKET, INC., MARKET PLACE RULES
(2003) [hereinafter NASDAQ RULES], available at
[Link] =
%2Fnasdaq%2Fmain%2Fnasdaq-equityrules%2F.
5
Sarbanes-Oxley Act of 2002, § 301.
6
FINANCIAL REPORTING COUNCIL, REPORT OF THE COMMITTEE ON THE FINANCIAL ASPECTS
OF CORPORATE GOVERNANCE (1992) available at [Link]
[hereinafter the Cadbury Committee Report].
directors has also resulted in readjustment of corporate governance norms in various
countries.7 This was a reaction primarily to ensure the prevention of corporate governance
scandals such as those involving Enron and WorldCom in their respective countries.

More specifically with reference to independent directors, Dahya and McConnell find that
during the 1990s and beyond, “at least 26 countries have witnessed publication of guidelines
that stipulate minimum levels for the representation of outside directors on boards of publicly
traded companies.”15 This demonstrates the significant impact of Western-style corporate
governance norms (particularly the independent director) on other countries within such a
short span of time.
This Article analyzes the effect of incorporating the independent director concept into one
such country, being India. In 2000, the Securities and Exchange Board of India (SEBI)
mandated that all large public listed companies in India are to have a minimum number of
independent directors.8 Since then, ongoing reforms by SEBI have solidified the requirement
of board independence as a prerequisite for enhanced corporate governance.

Thus, in the view to bring a substantial change in the position and selection of the
Independent Directors the new Bill that is still pending for approvals carry the definition and
also at various places defines the role, functions and duties of the Independent Directors
(IDs). The major issue that the different Corporate Governance Committees addressed was
regarding the independence of the IDs, due to the fact of the liability that is imposed on the
IDs. The new Bill also tries to reduce the same by discharging the IDs from the Criminal
liability that earlier was imposed on to them as the Companies act didn’t define the scope or
even the precise definition of the IDs.

EMERGING ROLE OF INDEPENDENT DIRECTORS' COUNSEL9

Over the last thirty years and more, we have seen the emergence of a distinctive role in the
boardroom: Counsel for the independent directors. The role has emerged out of the
engagement of counsel in several specific contexts for specific tasks. In this section, we
review that history.

THE SPECIAL LITIGATION COMMITTEE IN DERIVATIVE SUITS

When shareholders seek to sue directors for a breach of fiduciary duty, they typically must do
so through a derivative suit, that is, a suit that is brought on behalf of the corporation. The
board ordinarily has the ultimate decision over whether the corporation should prosecute
litigation. In a derivative suit, a shareholder seeks to displace the board of directors, or more
particularly a decision or inaction. As a result, the shareholders' suit is subject to special

7
The requirement in China of independent directors is said to be a transplant from the U.S. Donald C. Clarke,
The Independent Director in Chinese Corporate Governance, 31 Del. J. Corp. L. 125, 129 (2006) [hereinafter
Clarke, Independent Directors in China]; Chong-En Bai, et al., Corporate Governance and Firm Valuations in
China (2002), available at [Link] at 2.
8
Securities and Exchange Board of India, SMDRP/POLICY/CIR-10/2000 dated Feb. 21, 2000, available at
[Link]
9
Geoffrey C. Hazard, Jr. and Edward B. Rock, A New Player in the Boardroom: The Emergence of
the Independent Directors' Counsel, The Business Lawyer, August, 2004, 59 Bus. Law. 1389.
Source Lexisnexis.
requirements. In particular, shareholders must assert that the board is unable, unwilling, or
incapable of acting.

In corporate law this issue is normally resolved through determination of whether

shareholders must make a demand on the board of directors to sue ("demand required") or
whether the board is unable to make such a decision ("demand excused"). When demand is
required, and the board decides not to pursue an action, that decision will typically be
reviewed under the deferential business judgment rule.

Under Delaware law, demand is excused if the shareholder establishes a reasonable doubt
that the directors are disinterested and independent, or that the challenged transaction
otherwise was not the product of a valid exercise of business judgment. 10 To meet this
requirement, the complaining shareholder must do more than name all the directors as
defendants; the complainant must also plead sufficient facts to create a reasonable doubt of
board independence in the mind of a Delaware chancellor.

What, then, happens if demand is excused? It was once the rule that when demand was
excused, the derivative plaintiff simply prosecuted the claim. Delaware's approach shifted,
however, during the 1980s. In the seminal case of Zapata Corp. v. Maldonado,11 the
Delaware courts took the view that the board's lack of independence that led to excusing
demand was not necessarily permanent or irreversibly disabling. In particular, if the board
established a special committee of uninvolved directors (typically newly appointed ones), and
delegated the decision whether to proceed with the litigation to that committee, then the
committee could assume the authority of the board, and reassert control over the litigation.
That has become the established practice not only in Delaware but in other jurisdictions as
well.12

Section 132, of the Companies Bill, 2009:13

Defines IDs as:
(5)"'Independent director", in relation to a company, means a non-executive director of the
company, other than a nominee director:-
(a) who, in the opinion of the Board, is a person of integrity and possesses relevant expertise
and experience;
(b) who, neither himself nor any of his relatives-
(i) has or had any pecuniary relationship or transaction with the company, its holding,
subsidiary or associate company, or its promoters, or directors amounting to ten per cent. or
more of its gross turnover or total income during the two immediately preceding financial
years or during the current financial year;
(ii) holds or has held any senior management position, position of a key managerial personnel
or is or had been employee of the company in any of the three financial years immediately
preceding the financial year in which he is proposed to be appointed;
10
Aronson v. Lewis, 473 A.2d 805 (Del. 1984).
11
430 A.2d 779 (Del. 1981).
12
See Auerbach v. Bennett, 393 N.E.2d 994 (N.Y. 1979).
13
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(iii) is or has been an employee or a partner, in any of the three financial years immediately
preceding the financial year in which he is proposed to be appointed, of-
(A) a firm of auditors or company secretaries in practice or cost auditors of the company or
its holding, subsidiary or associate company; or
(B) any legal or a consulting firm that has or had any transaction with the company, its
holding, subsidiary or associate company amounting to ten per cent. or more of the gross
turnover of such firm;
(iv) holds together with his relatives two per cent. or more of the total voting power of the
company; or
(v) is a Chief Executive or director, by whatever name called, of any non-profit organisation
that receives twenty-five per cent. or more of its income from the company, any of its
promoters, directors or its holding, subsidiary or associate company or that holds two per
cent. or more of the total voting power of the company; or

(C) who possesses such other qualifications as may be prescribed.

(6) An independent director shall not be entitled to any remuneration other than sitting fee,
reimbursement of expenses for participation in the Board and other meetings and profit-
related commission and stock options as may be approved in the members.

There was no definition in the Companies Act, 1956 but the term “Independent Directors”
has been defined under Clause 49 of the amendment of the SEBI listing agreement14 as:

'Independent Director' means apart from receiving director’s remuneration, does not have
any material pecuniary relationships or transactions with the company, its promoters, its
senior management or its holding company, its subsidiaries and associated companies;

Independent Director is one who:

 is not related to promoters or management at the board level or at one level below the
board;
 has not been an executive of the company in the immediately preceding three financial
years;
 is not a partner or an executive of the statutory audit firm or 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. This will also apply to legal firm(s) and consulting firm(s) that
have a material association with the entity.
 is not a supplier, service provider or customer of the company. This should include lessor-
lessee type relationships also; and
 is not a substantial shareholder of the company, i.e. owning two percent or more of the
block of voting shares.

Companies (Amendment) Bill, 2009

Insertion of new section 312A

14
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After section 312 of the Principal Act, the following section shall be inserted namely,-
 [Link] to Independent Directors from criminal liability:-(i) Notwithstanding
anything to the country contained in this act or in any other Law for the time being in
force, any Independent Director on the Board of Directors of a Public Limited Company
shall not be liable or punishable for any act or omission by the Company or any officer of
the Company which constitutes a breach or violation of any of the provisions of this Act
or any other law for the time being in force.
 (ii) No arrest warrant shall be issued against an Independent Director without
authorization by a judge of the rank of the District Judge, who shall give to the
Independent Director an opportunity of being heard before issuing such authorization:
 Provided that the aforesaid provisions in this Section shall not apply if such Independent
Director was directly involved in or responsible for such breach or violation or such
breach or violation had been committed with this knowledge or consent or he was guilty
of gross or wilful negligence or fraud in relation thereto.15

Comparing the earlier position and the present prospects of the IDs:

The present definition of the IDs is aimed at making sure that the independence of the IDs is
not lost. It is with a view to ensure that the corporate governance is maintained and is
achieved. The whole purpose of introducing the amendments in the Companies Bill 2009 is
that the committee reports in India and abroad from that of the Cadbury Committee report has
laid emphasis on the fact that the IDs should be made the active part of the BOD and
managing panel of public as well as the private companies. These IDs act not only to make
sure that there integrity and self esteem, is safeguarded but also act as watchdogs for the
investors who are not directly related to the company and due to the ignore and non
accessibility suffers a huge loss due to the failure to the big business giants. One of the
failures of such a company is SATYAM Scandal which was one that brought into light the
whole plight of the IDs and there non independence the Government after the Satyam case
has been now keen to introduce minimum qualification criteria for IDs.

The Ministry of Corporate Affairs has taken a step ahead and has formulated a voluntary
guideline that is aimed at defining the parameters to be followed for appointment of the IDs
and the remuneration etc. those are16:

“INDEPENDENT DIRECTORS

Attributes for Independent Directors:

i. The Board should put in place a policy for specifying positive attributes of
Independent Directors such as integrity, experience and expertise, foresight,
managerial qualities and ability to read and understand financial statements.
Disclosure about such policy should be made by the Board in its report to the
shareholders. Such a policy may be subject to approval by shareholders.

15
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 ii. All Independent Directors should provide a detailed Certificate of Independence at the
time of their appointment, and thereafter annually. This certificate should be placed
by the company on its website, if any, and in case the company is a listed company,
also on the website of the stock exchange where the securities of the company are
listed.
Tenure for Independent Director
i. An Individual may not remain as an Independent Director in a company for more than
six years.
ii. A period of three years should elapse before such an individual is inducted in the
same company in any capacity.
iii. No individual may be allowed to have more than three tenures as Independent
Director in the manner suggested in 'i' and 'ii' above.
iv. The maximum number of public companies in which an individual may serve as an
Independent Director should be restricted to seven.

Independent Directors to have the Option and Freedom to meet Company Management
periodically
i. In order to enable Independent Directors to perform their functions effectively, they
should have the option and freedom to interact with the company management
periodically.
ii. Independent Directors should be provided with adequate independent office space and
other resources and support by the companies including the power to have access to
additional information to enable them to study and analyze various information and
data provided by the company management.”

Conclusion:

Corporate India should have a vested interest in preventing and minimising corporate frauds
and scams. One effective tool in this regard is to reinforce the institution of audit.
A sure way of reinforcing the institution of audit is effective oversight provided by audit
committees. Independent directors on audit committees provide one of the best ways of
reinforcing both internal audit and annual statutory audit. However, it should be kept in mind
that independence alone without competence can hardly make for a good independent
director.
If Corporate India is serious about raising the bar on governance standards, it should appoint
highly competent independent directors after a thorough, even global, search.
This brings up the next question of appropriate remuneration for competent independent
directors. The popular saying goes, "When you offer peanuts you get only monkeys.'' This is
also true when it comes to independent directors. Without attractive remuneration, the best
persons will not offer themselves as independent directors.
It is erroneous to say that attractive remuneration will erode the independence of independent
directors.
This may happen in the short term. But if large corporations start offering attractive
remuneration as a norm, competent independent directors, who are not many in number, will
have a choice and will not compromise their independence.
When India is slowly but surely integrating with the global economy, the need for a global
reach and size cannot be ignored by the top Indian companies. Quite a few of the top hundred
companies in India today are owned predominantly by families. Such companies will have to
grow at an exponential rate in order to acquire a global size and reach. And for this they need
to raise huge capital, domestic as well as foreign. This can be done well only if their
governance standards are quite high.