Independent directors constitute at least one-third of their boards will be delisted

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Companies that fail to comply with SEBI’s revised ‘clause 49’ to ensure that independent directors constitute at least one-third of their boards will be delisted.

To ensure corporate governance the securities and Exchange Board of India (SEBI) has stipulated that effective from January 2006 at least one-third of the directors on the board of a company should comprise “independent directors”. 

The revised clause 49 stipulates that in companies which have executive chairmen, at least 50 per cent of the board is required to have independent directors. For companies with non-executive chairmen one-third of the board must comprise independent directors.

Non-compliance with the provisions of corporate governance in clause 49 would invite penalties such as suspension of trading and delisting from the stock exchange.
While SEBI can delist a company for non-compliance, even individual stock exchanges have been empowered to suspend the trading of shares of defaulting companies.

The onus of complying with this provision will not be restricted to companies listed on the stock exchanges; the JJ Irani Committee has recommended that the provisions apply to all “large” companies and has left it to the government to define the term “large.” However, this provision also applies to even subsidiaries of publicly-listed companies and indications suggest that it may be extended to deemed public companies and, perhaps, even closely-held large private companies.

In fact, the government has indicated that it would, by December 31, 2005, bring down its representation on the board of the Oil and Natural Gas Corporation, to enable the oil major to conform what is now called the revised clause 49 of the ‘listing agreement’.

According to Y S Malik, joint secretary, company affairs ministry 3,000 to 4,000 people would be required to function as independent directors in about 6,000 listed companies, and various industry bodies have been asked to draw up a list of such persons. The government has estimated that corporate India will need 3,000-4,000 “independent directors” within the next few months to comply with SEBI’s listing requirements.

Studies have shown that “firms with stronger shareholder rights had higher firm value, higher profits, higher sales growth, lower capital expenditures, and fewer corporate acquisitions.” Investors who invested in shares of businesses with the strongest democratic rights and disposed-off their investments in those with the weakest rights “would have earned abnormal returns of 8.5 per cent per year during the sample period.”

Key institutional investors are shifting from trading to owning. As promoter-owners grapple with the issues of corporate governance, they are simultaneously reinventing systems of corporate monitoring and accountability. The movement to more democratic forms of corporate governance by empowering investors is important not only for creating wealth; it cuts directly to our ability to maintain a free society.

The issue of corporate governance and independent directors are closely inter-linked. The Irani committee has expressed the opinion that the presence of independent directors on the boards of companies in adequate numbers would help in improving corporate governance.

Role of an independent director
Independent directors are therefore also seen as a check on the management of companies, as an oversight mechanism, apart from the value addition that they bring to board deliberations. This is to ensure that action for wrongdoing by the majority stake holders who control the management by holding a majority of their own shares, is not hampered.

A director’s fulfilment of fiduciary responsibilities requires more than the mere absence of bad faith or fraud. Representation of the financial interests of others imposes on a director an affirmative responsibility to protect those interests and to oversee with a critical eye.

The definition of independent directors varies between that laid down under section 292A of the Companies Act 1956 and as per clause 49 of the ‘listing agreement’ issued by SEBI.

Independent directors according to Companies Act are defined as persons who:

  • Are not relatives of the chairman, managing director, whole time director, or the company secretary
  • Should not have been auditors, internal auditors, legal advisors or consultants to the company during any of the preceding three financial years
  • Should not have been suppliers, vendors or customers of the company
  • Should not hold below two per cent of the shares of the company, presently or in past
  • Should not have held any position in the company
  • Should not have been a director for a continuous period of nine years
  • Nominee directors of banks or FIs cannot be considered independent directors

Independent directors according to SEBI’s clause 49 of the listing agreement:

  • Should not be related to promoters or the management at the board level or at one level below the board
  • Should not have been a partner or an executive of the statutory audit firm or an internal audit firm or legal and consultancy firm, during the last three years
  • Should not have been suppliers, service providers or customers of the company
  • Should hold below two per cent of the shares of the company
  • Should not have been an executive of the company in the immediately preceeding three financial years
  • Appointment of non executive director a beyond continuous period of nine years not permissible
  • Nominee directors of banks or FIs will be considered as independent directors

Jay Lorsch, professor at Harvard, writing in the Financial Times (May 27, 2005), concludes that “well intentioned (independent) directors find that they have insufficient time and knowledge to perform their jobs well”.

To ensure that corporates are able to find qualified independent directors, the Bombay Chartered Accountants Society has undertaken to train professionally eligible individuals as independent directors send this article to a friendthrough study courses covering the changing business environment, corporate governance, the legal framework, risk management, auditing, etc. 

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