Independent directors act as guardians of ethical conduct and strategic decision making ensuring the organizations’ success. Institution of independent directors play a crucial role in ensuring the director’s accountability for their actions. Independent directors are appointed on the board of the company in the role of trustees of shareholders who would protect their interests in the company. However, there are issues that persist with their actual independence in the company. There has been plethora of scams both in Bharat and in other jurisdictions where the role of independent directors could have prevented them from happening had the independent directors been more vigilant and performed their functions as per the standards. Hence, it has been argued that there are various issues subsisting within the institution of independent directors, this paper is an attempt to identify the challenges plaguing them and hampering their effective functioning and covers recent case studies on the subject.
Introduction
Company as a Legal Person
As per the recorded history, companies are in existence since multiple centuries. The earliest example of a company takes us back to the year 578 to Japan. However, from the Bharat standpoint we can trace it back to the 18th Century as per the recorded history of the Company form of organization. The earliest record of this being the Wadia Group which is still in existence even after 200 plus years. Thus, the long history reflects a perpetual existence which is also one of the peculiar features of the Company form of organization.
The word "company" is derived from two Latin words that are "com" & "panis" which means "together" & "bread" respectively. So, it literally means that a company is an association of persons who took their meals together.
Definition: According to section 2 clause 20 of the Companies Act, 2013 a "company" means association of a person formed or registered under either present company laws, which is Companies Act, 2013 or previous company laws, which is Indian Companies Act, 1956/1913/1882 etc. Here, Association of Person (AOP) belong to two different types.
Incorporated AOP:
A single person distinct from the members who constituted it. Having such legal rights to make a contract and can purchase any property etc. It can come into existence through either the company legislation or by special act of Parliament called statutory corporation.
Unincorporated AOP:
Mere collection/aggregation of individuals for example partnership firms are not registered under the act and don't have any legal identity.
With the peculiar features the company does provide many benefits such as limited liability, separate legal entity, transferability of shares, perpetual succession, etc. These features are at the risk of abuse by the people who are at the helm of affairs of the company, this is because with all the features mentioned above there is need for people to run the affairs.
A usual structure of a company consists of the Board of Directors (BOD) at the top tier followed by the management which includes the Chief Executive Officer (CEO), Chief Finance Officer (CFO) and other senior management staff followed by the employees of the company who work in various departments. BOD is the governing body of a company, whose members are elected by shareholders to set strategy, oversee management, and protect the interests of shareholders and stakeholders. To conclude, though a company gets a legal existence independent of the shareholders the execution of the day-to-day management is dependent on the policies and practices of the individuals in authority which are the BOD and the management.
History of Corporate Governance in Bharat (India)
Corporate Governance concept emerged in Bharat after the second half of 1996 due to economic liberalization and deregulation of industry and business. With the changing times, there was also a need for greater accountability of companies to their shareholders and customers. The report of Cadbury Committee on the financial aspects of Corporate Governance in the U.K. gave rise to the debate of Corporate Governance in Bharat.
Need for Corporate Governance arises due to separation of management from the ownership. For a firm to succeed, it needs to concentrate on both economic and social aspects. It needs to be fair to shareholders, customers, public at large, etc. It has various responsibilities towards employees, customers, communities and at last towards governance and it needs to serve its responsibilities at all aspects.
The “Corporate Governance concept” is in existence in Bharat from the Arthashastra time instead of CEO at that time there were kings and subjects. Today, corporate and shareholders replace them, but the principles are still same i.e., good governance. The concept of Corporate Governance hinges on total transparency, integrity and accountability of the management and the Board of Directors. The importance of Corporate Governance lies in its contribution both to business prosperity and to accountability.
In the age of globalization good Corporate Governance helps as a great tool for corporate bodies. It existed from Vedic times as the highest standards in Arthashastra to today’s set of ethics, principles, rules, regulations, values, laws etc as good Corporate Governance.
History of the concept of Independent Director
The concept of Independent Director in Bharat is unique; however, it does borrow from models of UK and US and has influence of Cadbury Committee and several other committees and of the Sarbanes-Oxley Act.
1996 was the year where CII formed a task force to develop and promote a Code of Corporate Governance to be adopted and followed by Indian companies. The task force recommended a “Desirable Corporate Governance: A Code” in 1998 which extensively discussed the issue of Independent Director (ID).
In the year 1999 SEBI setup a committee to promote and raise standards of Corporate Governance in India under the Chairmanship of Shri Kumar Mangalam Birla which led to the addition of Clause 49 on Corporate Governance in the listing agreement in the year 2000. This was applicable only to listed companies satisfying the prescribed thresholds.
In the year 2002 the Government appointed the Shri Naresh Chandra Committee which among other recommendations in line with international best practices recommended that the existing definition of Independent Director be made more precise. In the same year SEBI formed a committee under the Chairmanship of Shri N R Narayan Murthy for reviewing the implementation of Corporate Governance code by listed companies which led to revision of the definition of ID in Clause 49 on Corporate Governance.
As we see the discussion and relevance of the concept of ID is in use since introduction of clause 49 on Corporate Governance in listing agreement, however, the actual inclusion the ID was included in the Companies Act 2013 only.
Aims and Objective of the study
To discuss the Challenges of Independent Directors with the help of various real-life cases in corporate world which again highlight the importance and the need for Corporate Governance and the role of Independent Directors. Independent directors in Bharat face a unique set of challenges that can affect their ability to effectively oversee Corporate Governance. One of the main issues is the balancing act between their independence and the influence of major shareholders, which can sometimes lead to conflicts of interest.
Challenges of Independent Directors
Independent directors play a crucial role in the governance of corporations, acting as vital components of a board's structure. They are expected to provide unbiased judgment and oversight, free from the influence of internal management or significant shareholders. The challenges they face can be categorized from three different perspectives: Industry, Regulatory, and Stakeholder Expectations.
Industry perspective
1. Knowledge of Industry: One of the primary challenges they face is the need to keep a deep understanding of the industry in which the company operates. This includes staying abreast of the latest developments, trends, and competitive dynamics that could affect the company's performance and strategic positioning. IDs must also be able to assess the potential impact of new technologies, market disruptions, and changes in consumer behaviour on the company's business model and long-term viability.
2. Availability: Another significant challenge is the time commitment needed to fulfil their responsibilities effectively. IDs often serve on multiple boards and have other professional obligations, which can limit the time they can dedicate to each company. This can make it difficult to engage deeply with the complex issues facing the company and to develop the necessary insights to provide effective oversight and guidance.
3. Conflict of Interest: Furthermore, IDs must navigate potential conflicts of interest and ensure that their decisions are made in the best interests of the company and its shareholders. This requires a delicate balance between challenging management and supporting them in executing the company's strategy. They must also be vigilant in monitoring for any signs of mismanagement or unethical behaviour and be prepared to act decisively to protect the company's reputation and value.
4. Expectations of Industry Stakeholders: In addition to these challenges, IDs must also contend with the increasing expectations of industry stakeholders. These stakeholders expect IDs to not only oversee financial performance but also to ensure that the company is operating responsibly and sustainably. This includes addressing issues such as environmental impact, social responsibility, and corporate ethics.
To meet these challenges, IDs must possess a range of skills and attributes, including strong analytical abilities, strategic thinking, and the courage to ask tough questions and challenge the status quo. They must also be effective communicators, able to build consensus and foster an environment of open and constructive dialogue within the boardroom.
In summary, the industry perspective on the role of IDs is one that recognizes the critical importance of their contributions to Corporate Governance, while also acknowledging the significant challenges they face in fulfilling their duties. As the business landscape continues to evolve, the role of IDs will remain essential to ensuring the accountability, transparency, and success of corporations around the world.
Regulatory perspective
The regulatory perspective on IDs is deeply rooted in the principles of Corporate Governance, which emphasize transparency, accountability, and the protection of shareholder interests. Regulators across various jurisdictions have established guidelines and requirements for the inclusion of IDs on corporate boards to ensure that these principles are upheld.
1. Conflict of Interest: IDs are seen by regulators as a safeguard against potential conflicts of interest that may arise when a board is composed solely of insiders or representatives of major shareholders. By bringing an external and impartial viewpoint to board deliberations, IDs help to ensure that the board acts in the best interests of all shareholders, not just a select few.
2. Complex web of laws and regulations: One of the key regulatory challenges for IDs is navigating the complex and often changing landscape of Corporate Governance laws and regulations. This includes understanding and complying with the requirements set forth by securities and exchange commissions, stock exchange listing rules, and other regulatory bodies. For example, the SEBI LODR, Companies Act 2013, etc provide specific criteria for director independence, which must be met for directors to serve on key committees such as audit, compensation, and nominating committees.
3. Corporate Governance oversight: Regulators also expect IDs to play a critical role in overseeing key areas of Corporate Governance, such as financial reporting, executive compensation, and risk management. This oversight is crucial in preventing corporate scandals and ensuring that the company's financial statements accurately reflect its financial position and performance.
4. Ever changing regulations: For example - The rise of environmental, social, and governance (ESG) considerations has added another layer of complexity to the role of IDs. Regulators increasingly expect boards to address ESG issues proactively and to integrate them into the company's strategic planning and risk management processes. IDs must therefore be knowledgeable about ESG trends and best practices and be able to assess the potential impact of ESG factors on the company's business.
In conclusion, the regulatory perspective on IDs underscores their importance in upholding the integrity of Corporate Governance. While the role comes with significant challenges, it is also an opportunity for IDs to make a meaningful contribution to the success and sustainability of the companies they serve. Their ability to meet these challenges is essential for maintaining investor confidence and ensuring the long-term health of the capital markets.
Stakeholders Expectations
Stakeholder expectations from independent directors are diverse and multifaceted, reflecting the broad range of interests that these directors are expected to balance. Stakeholders encompass a wide array of groups and individuals, including shareholders, employees, customers, suppliers, and the broader community, each with their own unique perspectives and concerns.
1. Shareholders: For shareholders, IDs are seen as protectors of their investment. They rely on IDs to oversee the company's management and ensure that strategic decisions are aligned with the goal of long-term value creation. Shareholders expect IDs to provide a counterbalance to the potential short-term focus of executive management, which may be driven by performance metrics and compensation structures. They also look to IDs to exercise due diligence in monitoring financial practices and corporate strategy to prevent mismanagement or unethical behaviour that could harm the company's value.
2. Employees: Employees view IDs as advocates for a fair and safe working environment, and for policies that support growth and development within the company. They expect IDs to ensure that their voices are heard and considered in board decisions, particularly those that affect their welfare and job security.
3. Customers: Customers expect IDs to ensure that the company provides high-quality products and services that meet their needs. They also look for IDs to hold the company accountable for ethical business practices and to contribute to a culture that values customer satisfaction and loyalty.
4. Suppliers: Suppliers seek assurance from IDs that the company will be a reliable partner and that contracts will be fair and honoured. They expect IDs to foster transparent and equitable business relationships.
5. Broader Community: The wider community expects IDs to ensure that the company operates responsibly and sustainably. This includes overseeing environmental practices, social contributions, and ethical conduct. IDs are expected to ensure that the company's operations align with societal values and contribute positively to the community.
6. Effective Stakeholder Engagement: To meet these expectations, IDs must engage effectively with stakeholders. This involves establishing open channels of communication, where stakeholders can express their opinions and provide feedback. IDs should facilitate regular meetings, reports, or digital platforms for this purpose. They must also develop and implement engagement strategies tailored to the needs of different stakeholder groups, such as CSR initiatives for the community or negotiation and contract discussions with suppliers.
7. Building Trust and Credibility: Building trust and credibility among stakeholders is another critical expectation. IDs should act transparently and ethically, ensuring that stakeholder interests are genuinely considered in board decisions. They must also be adept at negotiation and conflict resolution, balancing the often-competing interests of various stakeholder groups.
8. Integrating Stakeholder Interests into Business Strategy: Finally, stakeholders expect IDs to integrate their interests into the company's business strategy. This includes prioritizing ESG considerations and ensuring that the company's strategic planning reflects an integrated approach to decision-making that takes into account the interests of employees, communities, and the environment.
In summary, stakeholders place high expectations on IDs to act as guardians of their interests, ensuring that the company is managed in a way that is not only profitable but also responsible and sustainable. IDs must navigate these expectations with skill and integrity, balancing the diverse needs of stakeholders while maintaining their independence and objectivity. Their success in meeting these expectations is crucial for building and maintaining trust in the company's governance and for the long-term success of the organization.
Case Study:
LEEL Electricals Ltd
(Incorporated in 1987)
WTM/AB/CFID/CFID/30277/2024-25 1
The Securities and Exchange Board of India (SEBI) issued a final order dated April 18, 2024, regarding LEEL Electricals Ltd (LEEL)., which was under scrutiny following allegations of financial irregularities. The case revolved around the misuse and diversion of funds amounting to Rs. 472.11 Cr, which became known after the company's consumer durables (CD) business was acquired by Havells India Ltd. for Rs. 1550 Cr.
Key points from the SEBI order include:
• Fund Diversion: LEEL was accused of transferring debit balances from related parties to Capital Work-in-Progress (CWIP), inflating the CWIP without proper justification. This included a fictitious entry that reduced the receivable balance of a related party by Rs. 10 Cr, leading to a misrepresentation of profits.
• Misrepresentation of Financial Statements: The company allegedly overstated profits by Rs. 356.6 Cr. through improper accounting practices. The SEBI highlighted the failure to obtain necessary approvals for related party transactions and non-compliance with Corporate Governance norms under the Listing Obligations and Disclosure Requirements (LODR) Regulations.
• Governance Failure: The Audit Committee (AC) meetings were reportedly not convened, leading to a breakdown in governance and oversight.
• Improper Financial Transactions: There were write-offs of consultancy charges and payments of an incentive of Rs. 4 Cr. to key management personnel without Board approval.
• SEBI's investigation revealed substantial evidence of fund diversion and misrepresentation of financial statements. The forensic audit indicated inconsistencies between reported sales and GST returns, suggesting manipulation of financial records. As a result, the SEBI concluded that the actions of the Noticees constituted a breach of regulations, specifically the Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market (PFUTP) Regulations and indicated a systemic failure in Corporate Governance.
• SEBI imposed a penalty of Rs 14.20 Cr on the Managing director, whole-time directors, key management personnel, and members of the audit committee of LEEL for their complicity in the misappropriations and misstatements leading to the company's liquidation.
SEBI order against LEEL had significant implications for Independent Directors, particularly in terms of their accountability and the expectations of their role in Corporate Governance. The order highlighted the need for Independent Directors to be diligent and proactive in their duties, especially as members of the Audit Committee (AC). Here are some key points regarding the implications for independent directors:
• Increased Accountability: SEBI order imposed a fine on the IDs of LEEL for failing to fulfil their statutory duties, emphasizing that ignorance of financial matters is not an acceptable defence.
• Diligence in Oversight: SEBI order serves as a reminder that IDs must understand their roles and responsibilities and act diligently. They cannot rely solely on assurances from management and must actively participate in governance to protect shareholder interests.
• Financial Literacy: IDs particularly those on the Audit Committee, are expected to possess or acquire a certain level of financial literacy to effectively oversee financial statements and disclosures.
• Risk of Penalties: The order indicates that IDs can face substantial penalties for governance failures. This risk underscores the need for them to ensure that they are fully aware of and compliant with all relevant regulations.
• Professional Reputations: IDs professional reputations are at stake if they are found to be complicit or negligent in cases of financial misconduct. The SEBI order demonstrates that the consequences of such failures can extend beyond financial penalties to include reputational damage.
• Stricter Norms and Scrutiny: SEBI is tightening norms for IDs, which means that there will be increased scrutiny of their actions and decisions, particularly in cases involving financial misconduct within companies.
Considering the SEBI order, it is clear that the role of IDs is becoming more demanding and carries greater responsibility. IDs must be prepared to meet these challenges by ensuring they have the necessary knowledge and skills to fulfil their duties effectively and to safeguard the interests of shareholders and the integrity of the financial markets.
Southern Ispat and Energy Ltd
(Incorporated in 1995)
WTM/GM/IVD/ID4/13810/2021-22 2
• Securities and Exchange Board of India (SEBI) has been actively monitoring and regulating the activities of corporations to protect the interests of investors and ensure fair trading practices. In the case of Southern Ispat and Energy Ltd. (SIEL), SEBI had taken significant actions in response to certain irregularities via order dated October 22, 2021.
• The case of SIEL involved several specific irregularities that caught the attention of the SEBI. The primary issue was the manipulation in the issuance of GDRs. It was found that for many of the GDR issues, a loan was taken by a foreign entity to subscribe to the issue, and this loan was secured against the proceeds of the same issue. This practice was deemed fraudulent as it misrepresented the financial backing of the GDRs and potentially misled investors.
• During the investigation, SEBI discovered that SIEL had made two issues of GDRs, one on August 10, 2010, and another on June 10, 2011. The investigation focused on whether the shares underlying the GDRs were issued with proper consideration and whether appropriate disclosures were made by the company while issuing the GDRs.
• SEBI's findings led to the conclusion that the company had entered into a Pledge Agreement with the European American Investment Bank AG (EURAM Bank), pledging the proceeds of the same GDR issue for a loan availed by Vintage FZE for subscribing to the GDRs issued by the company. This arrangement was not disclosed to the investors, which is a violation of the mandatory disclosure requirements.
• As a result of these irregularities, SEBI imposed a penalty totalling Rs 10.7 Cr. on SIEL and four individuals associated with the case. The penalty was for the alleged irregularities in the GDR issues and for the failure to make the necessary disclosures as required by the regulations.
• IDs faced severe penalties for their failure to fulfil their statutory duties. These duties include due diligence in financial matters and ensuring that all necessary disclosures are made accurately and in a timely manner. SEBI order against IDs in the SIEL case underscored their negligence in monitoring financial transactions and aiding in financial misrepresentations, which resulted in significant penalties and underscored the importance of financial literacy, legal expertise, and an understanding of risk management and internal controls within companies.
• IDs, particularly those serving on Audit Committees, are subject to additional scrutiny and are expected to possess relevant experience and financial literacy. The recent order by SEBI in cases like SIEL have highlighted the heightened accountability of IDs and the serious consequences they face if found negligent in their duties. A separate release order was issued for RC No. 6609/2023 against Mr. V Manikandan (Independent Director) in the matter of SIEL Limited, detailing the recovery proceedings who was the Chairman of the Audit Committee for SIEL.
Fortis Healthcare Limited
(Incorporated in 1996)
WTM/GM/IVD/ID2/48/2020-21 3
Securities and Exchange Board of India (SEBI) issued an order regarding Fortis Healthcare Limited (FHL), which involved several entities in a case of alleged financial irregularities. The order addressed the violation of various regulations under the SEBI Act and the Prohibition of Fraudulent and Unfair Trade Practices (PFUTP) Regulations. It was found that funds were diverted from Fortis Healthcare Limited (FHL) to certain entities, which were then used for the benefit of the promoters of FHL.
Key points from the SEBI order include:
• The interim order required Fortis Healthcare Limited and Fortis Hospitals Limited to recover approximately Rs. 403 Cr., along with interest, from various entities including RHC Holding Private Limited and others.
• These entities were directed to repay the amount with interest to Fortis Hospitals Limited within a specified time.
• SEBI imposed penalties totaling Rs. 38.75 Cr. on 32 entities, including Fortis Healthcare Holdings, for their involvement in the diversion of funds and misrepresentation to conceal the fraud.
• The investigation revealed a systematic scheme of fraud devised by the erstwhile promoters of FHL to funnel resources from the listed company for their benefit.
The specific charges against the IDs in the Fortis Healthcare SEBI order revolved around their alleged failure to fulfil their fiduciary duties and due diligence responsibilities. SEBI scrutinized the IDs for their role in the financial irregularities that led to the diversion of funds from Fortis Healthcare Limited (FHL).
• Failure to Exercise Due Diligence: IDs were charged with not exercising the required level of due diligence in their oversight of the company's financial practices, which allowed the diversion of funds to go unchecked.
• Inadequate Oversight: The order pointed out that the IDs did not effectively exercise their independent judgment or adequate oversight of the financial transactions that led to the misappropriation of funds.
• Non-compliance with Fiduciary Duties: SEBI's order suggested that the IDs failed to comply with their fiduciary duties, which include acting in good faith and in the best interests of the company and its shareholders.
• Aiding and Abetting Financial Irregularities: IDs were charged with aiding and abetting the systematic scheme of fraud by not taking appropriate actions to prevent the diversion of funds.
• Negligence in Safeguarding the Interests of Shareholders: IDs were accused of negligence in safeguarding the interests of the shareholders by failing to detect and prevent the misrepresentation in the financial statements of FHL.
As a result of these charges, SEBI imposed penalties on the IDs for their failure to fulfil their responsibilities.
FINDINGS
All the three cases discussed above collectively underscore the challenges faced by IDs in navigating their roles amidst complex legal frameworks and heightened regulatory scrutiny. They also highlight the importance of possessing the requisite expertise, commitment to governance standards, and an understanding of the financial aspects of the companies they serve. The evolving landscape suggests a move towards more stringent norms and greater accountability for IDs to prevent financial misconduct and protect the interests of all stakeholders. Implications of non-compliances are stringent and in all the three cases discussed we observe that the penalties whether monetary or non-monetary are levied on the IDs.
CONCLUSION
In conclusion, the role of IDs is laden with challenges that require a delicate balance of expertise, ethical standards, and a deep understanding of Corporate Governance.
Key takeaways include:
• Independent directors must navigate complex regulatory environments while maintaining their autonomy from management and significant shareholders.
• They are tasked with the oversight of critical areas such as strategy, financial reporting, and risk management, despite having limited visibility into day-to-day operations.
• The evolving landscape of corporate compliance demands that independent directors stay abreast of market trends and regulatory changes to effectively fulfil their roles.
• Balancing professional commitments with directorial duties is essential to ensure that independent directors can dedicate sufficient time and resources to their roles.
• Upholding independent judgment and mitigating conflicts of interest are paramount for maintaining the integrity of the board and the trust of stakeholders.
These challenges underscore the importance of continuous education, ethical leadership, and a commitment to transparency for independent directors to effectively contribute to the success and governance of their organizations.
BIBLIOGRAPHY
1. Companies Act
2. SEBI Act
3. SEBI LODR
4. MCA website
5. N.R. Narayan Murthy Committee on Corporate Governance, 2003.
6. Kumara Mangalam Birla Committee on Corporate Governance, 1999.
7. Cadbury Committee on Corporate Governance.
8. Annual Reports of Listed Companies provided in the NSE / BSE Portals, and the companies’ respective websites.
9. Guidance Note of Independent Directors.
10. https://www.sebi.gov.in/enforcement/orders/apr-2024/final-order-in-the-matter-of-leel-electricals-ltd-_82934.html
11. https://www.sebi.gov.in/enforcement/orders/oct-2021/order-in-the-matter-of-gdr-issue-of-southern-ispat-and-energy-limited_53462.html
12. https://www.casemine.com/judgement/in/5fb4bc56342cca35177fc5e3
