Compulsory Corporate Literacy for Independent Directors: Last Resort To Ensure Efficiency?

[By Saket Agarwal]

The author is a fourth year student of National Law University, Jodhpur and can be reached at saketagarwal16@gmail.com

Introduction

India in the past few years has been a major victim of corporate frauds including the Nirav Modi scam. When it came to affixing liability, one person was found to be negligent in performing his duties in almost all cases, the independent director of the company. However, independent directors have attempted to evade liability claiming lack of knowledge. To fix this issue, the government is planning to conduct compulsory exams to qualify as an independent director.[i] This Blog post aims to assess the feasibility of such proposed examination.

Section 149(6) of the Companies Act, 2013 [“Act”] defines independent director as “a director who is not a managing director or a whole time director or a nominee director”. Schedule IV of the Act prescribes the supervisory function of independent directors over board of directors. They are expected to act as internal watchdog over affairs of the company. Their liability under Section 149(12) of the Act is limited to acts or omissions occurring within his knowledge, attributable through Board processes, and with his consent or connivance or where he had not acted diligently. It appears that the plan of conducting the proposed examination intends to target this aspect of knowledge. The proposed exam will test various facets of an independent director like business ethics, capital market regulations, etc. The proposed exams will ensure that the independent directors do not claim lack of knowledge; where the aspect of knowledge will depend upon the facts and circumstances of each case. However, there exists a basic lacuna in this premise. The argument presented by the government presupposes that lack of knowledge among independent directors is only due to the lack of corporate literacy, which might not happen in every case.

Independent directors: a flawed concept in itself

The motive behind introducing the position of independent director was to highlight irregularities going on within the company. The duty was considered so crucial that any failure in his behalf could make him personally liable. In the case of Zylog Systems,[ii] the question of liability of independent directors was discussed regarding non-payment of dividend by the company post declaration. The decision was given in favour of independent directors because they registered their protests in the minutes of the meetings and resigned in protest later. This case shows that the independent directors are confined to stage protests against the unlawful actions of the company and to take exit if the company does not relent. They do not have any actual powers to perform their functions for which they were appointed.

The author contends that Schedule IV of the Act is a complete enigma on role of independent directors. Therefore, the proposed exams will not ensure ‘independence’ of independent directors. Schedule IV of the Act advocates for strong role of independent directors without any influence.[iii] Further, it asserts that independent directors shall bring objectivity in performance of the board of directors.[iv] However, their re-appointment is subject to their evaluation by board of directors. Moreover, they can be easily removed through an ordinary resolution.

Existing provisions on the issue

There is nothing new in the proposal of financial literacy for independent directors. Financial literacy is something which was there previously as well in the Act. Clause 49 of SEBI Listing Agreement of 2004 on corporate governance provides for audit committee in a listed company. Such an audit committee should consist of at least three directors where the independent directors shall be two-third of total members. Section 177 of the Act makes it mandatory for all members of the audit committee to be financially literate. The revised Clause 49(II)(B)(7) of Equity Listing Agreement makes it mandatory for the companies to conduct compulsory training of independent directors. The author suggests that intent behind this move might be to ensure that the independent directors are vigilant about their responsibilities in the company. To ensure its compliance, a disclosure was made mandatory in the annual report along with details of such training. If the sufficient provisions are already present to keep a check on their knowledge, then it is futile to bring in another separate provision.

The case of Dr. Sambit Patra: independent director of ONGC

BJP’s National Spokesperson, Dr. Sambit Patra was appointed as the independent director of Oil and Natural Gas Corporation [“ONGC”] in 2017. His appointment was challenged in the court for his lack of sufficient financial knowledge required in a director of a company. [v] The Court held that there are diverse areas which a corporation needs to take care of when it is operating in a society. The importance of the knowledge in these different areas cannot be ruled out. Moreover, it is mandatory for every company to perform corporate social responsibility [“CSR”]. CSR ensures the inclusive growth of each section of the society which could not keep pace with the rapid industrialization.[vi] Schedule VII of the Act containing CSR activities have a direct impact of the environment and human rights. The court held that relevance of a medical expert in the board of directors in such a case cannot be ignored.

Rule 5 of the Companies (Appointment and the Qualification of Directors) Rules, 2014 provide for qualifications of an independent director in one or more fields of finance, law, management, sale, etc. The author feels that such a wide ambit of the above provision was deliberately kept to maintain that the company cannot isolate itself from the society. Therefore, the officials of the company cannot confine themselves to the matters solely related to company. Having a separate examination would therefore be redundant.                      

Violation of Article 14 of the Constitution of India

The current norms of the regulatory authorities have made the liability of the independent directors at par with the executive directors of the company although they may not enjoy equal powers and remunerations. In the Neesa Technologies case,[vii] an independent additional director was held liable for returning the money raised through non-convertible debentures by the company in non-compliance with the Act and the SEBI (Issue of Listing and Debt Securities) Regulations, 2009. As discussed previously, an independent director merely oversees the functions and is not actively involved in day to day activities. However, he was held liable just like any other executive director because his name was on the board of directors in spite of him being an independent director.

The proposed examination will lead to violation of Article 14 of the Constitution. Article 14 provides for “treating equals equally and unequals alike”. The test to assess the violation of article 14 is two-pronged i.e. whether there is an intelligible differentia in bringing such classification and whether the classification has any rational nexus with the object to be achieved. But here the independent director and the executive director who are unequals in terms of their functioning are being treated alike. It is pertinent to note that there are no plans for taking exams of the executive directors who are the actual culprits behind these frauds in most of the cases. This shows that there will be no intelligible differentia and no reasonable nexus with the object sought to be achieved in this proposed scheme i.e. to control the occurrence of frauds.

Recommendations

The author recommends that focus should be on conducting formal training of independent directors instead of the proposed examination. Although, the duties have already been provided under the Schedule IV of the Act, the training will help independent directors to understand their duties practically. Further, these training sessions would be conducted by the companies at their own level, thus allowing them flexibility in the areas of training. However, to ensure the compliance; a provision of mandatory disclosure could be introduced in the Act. Additionally, there is a need for reducing the dependence of independent directors on board of the company in terms of their reappointment, performance appraisal etc. The audit committee should be entrusted with the responsibility of independent directors. However, in case an independent director is interested in the deliberations of audit committee as regarding his reappointment, then he shall not be a part of it. This will limit the exchange of favours between the two parties and allow the independent directors to work freely. The liability of independent directors majorly falls under Companies Act and Section 11B of SEBI Act, 1992. Though these statutes are civil in nature but they have penal provisions as well. Section 149 of Companies Act dealing with the liability of the independent directors should be strictly construed. When it refers to the acts and omissions of the independent directors while deciding their punishment, then those should be exclusively of the independent directors for which they were originally appointed. Any attempt to include the duties of executive directors by way of liberal interpretation should be highly discouraged.

Endnotes

[i] Shruti Srivastava, Company Directors will have to sit for Exams in India after Scandals, Eco. Times, June 12, 2019, https://economictimes.indiatimes.com/news/company/corporate-trends/co mpany-directors-will-have-to-sit-for-exams-in-india-after-scandals/articleshow/69750946.cms.

[ii] SEBI Order In Respect of Mr. S. Rajagopal and Mr. V.K Ramani Independent Directors of Zylog Systems Limited, WTM/GM/EFD/26/June/2017, https://www.sebi.gov.in/enforcement/or ders/jun-2017/order-in-respect-of-mr-s-rajagopal-and-mr-v-k-ramani-independent-directors-of-zylog-systems-limited-_35138.html.

[iii] Schedule IV, Clause I(5), The Companies Act, 2013.

[iv] Schedule IV, Clause II(2), The Companies Act, 2013.

[v] Energy Watchdog v. Union of India & Ors., W.P.(C) No. 9269/2017 (India).

[vi] Report of the High Level Committee (to suggest measures for improved monitoring of the implementation of the Corporate Social Responsibility), http://www.companiesact.in/mailer/HL C_report_05102015.pdf.

[vii] SEBI Order In the Matter of Neesa Technologies Limited, WTM/MPB/EFD-1-DRA-IV/63/2018, https://www.sebi.gov.in/sebi_data/attachdocs/nov-2018/1543551262830.pdf.

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