India: Criteria For Independent Directors: Who Can Be?

Last Updated: 24 February 2015
Article by Suneeth Katarki and Ankita Gupta

Applicability

The debate around the appointment and governance of independent directors has remained unsettled for long. Prior to the enactment of Companies Act, 2013, ("Act"), the erstwhile Companies Act, 1956 contained no provisions with respect to independent directors. The only framework governing independent directors was contained in Clause 49 of the Listing Agreement ("Listing Agreement"), which is applicable only to listed companies. To ensure corporate governance and in what may be a respite to the shareholders especially in light of the Satyam aftermath, the provisions governing independent directors have now been introduced under Section 149 of the Act and Companies (Appointment and Qualification of Directors) Rules, 2014 ("Rules"). In furtherance of the enactment of the Act, the Securities and Exchange Board of India ("SEBI") on April 17, 20141 modified the Listing Agreement to bring it in line with the provisions of the Act and the Rules which would be applicable to all listed companies with effect from October 01, 2014. However, as detailed hereinafter, the amendments impose more stringent restrictions on listed companies than those contemplated under the Act. In a further attempt to harmonize the provisions, SEBI on September 15, 20142 notified further amendments to the Listing Agreement ("September Amendment") to suitably align it with the provisions of the Act.

Vide the September Amendment, SEBI has clarified that compliance with the provisions of Clause 49 shall not be mandatory, for the time being, in respect of the following class of companies:

  1. companies having paid up equity share capital not exceeding ten crore and net worth not exceeding twenty five crore, as on the last day of the previous financial year; and
  2. companies whose equity share capital is listed exclusively on the SME and SME-ITP platforms.

It is essential to note that with respect to the exception carved out under point (i) SEBI has explicitly specified that when the provisions of Clause 49 become applicable to a company at a later date, such company shall comply with the requirements of Clause 49 within six months from the date on which the provisions became applicable.

The new provisions under the Act and the Listing Agreement entail discussion, especially because as has been detailed hereinafter, two sets of overlapping and at times contradictory requirements have been brought into force.

Defining independent directors: The way forward

Section 2 (47) of the Act defines an independent director to mean the director referred to under Section 149 (5) of the Act. In what may have been an oversight, it is in fact Section 149 (6) that defines an independent director to mean a director other than a managing director or a whole-time director or a nominee director who conforms to the criteria mentioned therein.

One of the crucial criteria that warrants discussion is one set out under section 149(6) (c) of the Act. The said section states that independent directors shall have or had no pecuniary relationship with the company, its holding, subsidiary or associate company, or their promoters, or directors, during the two preceding financial years or during the current financial year. Additionally, another criteria prescribed under section 149(6)(d) of the Act is that an independent director's relatives should not have or had pecuniary relationship amounting to two percent or more of the gross turnover or total income or fifty lakhs or such higher amount as may be prescribed, whichever is lower, during the two preceding financial years or during the current financial year.

With regard to which transactions will be covered under the ambit of 'pecuniary relationship', for the purposes of section 149(6) (c) of the Act, the Ministry of Corporate Affairs ("MCA") has issued a clarification3 ("MCA Clarification"). The MCA Clarification states that a transaction entered into by an independent director with the company concerned, which is at par with a transaction with any member of the general public and at the same price as is payable by such member of public, will not be covered under the purview of 'pecuniary relationship' and is as such exempted from the provisions of Section 149 (6) (c) of the Act. It is interesting to note that the reasoning provided by MCA for this exemption is that since transactions in the ordinary course of business at arm's length price are excluded from the purview of related party transactions, the same logic must apply to adjudge a pecuniary relationship. It is pertinent to note that this exemption shall not apply to listed companies i.e. effectively, a transaction by an independent director, even if at arm's length basis, is not permissible for listed companies. Additionally, pecuniary relationship does not include receipt of remuneration, from one or more companies, by way of fee, reimbursement of expenses for participation in the board and other meetings and profit related commission approved by the members, in accordance with the provisions of the Act.

What is interesting to note however is that the MCA Clarification only elucidates the stance on the pecuniary relationship covered under section 149 (6) (c) of the Act but excludes the transactions covered under section 149 (6) (d) i.e. those relating to the transactions involving an independent director's relatives. This suggests that while the 'arm's length test' would be applicable to an independent director, the same will not be applicable to the relative of the independent director. This indicates a lacuna in law and requires to be addressed.

The Act also requires the individuals to submit a self-declaration confirming that they have satisfied the criteria prescribed under the Act.4

The Rules5, while prescribing certain criteria in addition to the ones laid down under the Act, require the independent director to possess appropriate skills, experience and knowledge in one or more fields of finance, law, management, sales, marketing, administration, research, corporate governance, technical operations or other disciplines related to the company's business.

The amended Clause 49 of the Listing Agreement defines independent director to mean a non- executive director, other than a nominee director, who possesses certain criteria, which have been elaborated in the Listing Agreement and which are mostly similar to those laid down under the Act and the Rules. In addition to the criteria laid down under the Act and the Rules, the Listing Agreement states that an independent director or any of his relatives shall not be a material supplier, service provider or customer or a lessor or lessee of the company. Further, an age qualifier has been prescribed to say that independent director will not be less than 21 years of age. It is worthwhile to note that the age qualifier of 21 years has been prescribed under the Act only for whole time directors, managers and managing directors6. This appears to be a blatant omission on part of the legislators.

As far as the criteria relating to pecuniary relationship of directors for listed companies is concerned, pursuant to the September Amendment, pecuniary relationship is now preceded by 'material'. This appears to be a watering down of the provision for listed companies which may owe its addition to the fact that the MCA Clarification does not apply to listed companies and the arm's length exemption is not applicable to listed companies. However, material has not been defined, nor any rationale given as to why this addition has been brought into force. The definition however, can be traced back to the Report of the Expert Committee on Company Law ("Report") by Dr. J.J. Irani dated May 31, 2005. In 2005, an expert committee constituted under the chairmanship of Dr. J.J. Irani ("Committee") dealt with the concept of independent directors when discussing the issue of Management and Board Governance. The Report outlined certain requisites when attempting to define independent directors, one of which was that the independent director should not have material pecuniary relationship with the company, promoters, directors, senior management, holding company, subsidiary and associate companies.

What would amount to a material transaction, was clarified in the Report as below:

  1. The concept of 'materiality' is relevant from the recipient's point of view and not from that of the company.
  2. The term 'material' needs to be defined in terms of percentage. In view of the Committee, 10% or more of recipient's consolidated gross revenue / receipts for the preceding year should form a material condition affecting independence.
  3. For determining materiality of pecuniary relationship, transactions with an entity in which the director or his relatives hold more than 2% shareholding, should also be considered.
  4. An independent director should make a self-declaration in a format prescribed to the board that he satisfies the criteria for being an independent director. Such declaration should be given at the time of appointment of the independent director and at the time of change in status.
  5. The board should disclose in the director's report that independent directors have given the above mentioned declaration and that in the judgment of the board they are independent. The board should also disclose the basis for determination that a particular relationship is not material.

However, considering the fact that material has not been defined under the September Amendment, this might lead to an open interpretation as to what amounts to 'material'.

Board composition: How many?

The Act7 mandates every listed company to have at least one third of the total number of directors as independent directors and further states that the Central Government may prescribe the minimum number of independent directors for a class of companies. The Rules8 prescribe at least two directors as independent directors for the following classes of public companies having:

  1. paid up share capital of ten crore rupees or more; or
  2. turnover of one hundred crore rupees or more; or
  3. in aggregate, outstanding loans, debentures and deposits, exceeding fifty crore rupees.

The Rules further go on to carve out a scenario wherein a higher number of independent directors have been specified in law for certain classes of companies, in which case the company shall comply with the requirements specified in such law. This clarifies the position that when law commands a higher number of independent directors for committees for certain classes of companies, as has been elucidated hereinafter; the company needs to comply with the more conservative requirement.

The Listing Agreement further mandates that where the chairman of the board of directors is a non-executive director, at least one-third of the board should comprise of independent directors; and where the non-executive chairman is a promoter of the company or is related to any promoter or person occupying management positions at the board level, and where the company does not have a regular non-executive chairman, at least one-half of the board should comprise of independent directors.

Considering the overlapping provisions in terms of the board composition prescribed under the Act (along with the Rules) and the Listing Agreement, a harmonious reading of both would demand that to ensure due compliance, the stricter of the requirements in such a case would apply and a listed company would have to ensure compliance under both the statues.

Public companies on the other hand, if falling under the criteria prescribed under the Rules, as detailed above, would adhere to the requirements stated under the Rules.

Private Companies: Reading in between the lines

A bare reading of the Act leads to the conclusion that there is no mandatory requirement for private companies to appoint independent directors. This implies that if private companies choose to appoint independent directors, there is no need for them to adhere to the requirements provided under the Act and Rules with respect to the number of independent directors required on the board. This leads to the most contentious issue which is whether the rest of the provisions regarding criteria, term, and liability will apply to independent directors appointed on the board of a private company. Taking the view that the application of these provisions to a private company might be far-reaching in scope would necessarily lead to the conclusion that the usage of the term 'independent directors' for a private company may just be axiomatic in nature and the intent of having them in a private company is just to ensure objectivity. On the contrary, another interpretation demands that independent directors for a private company will have to adhere to the remaining provisions for section 149, excluding those under Section 149 (4). What remains to be seen is which view the courts take.

Term for independent directors

As far as the tenure for independent directors, the Act9 provides for a term upto five consecutive years, along with eligibility for reappointment for another term upto five consecutive years on passing of a special resolution by the company and disclosure of such appointment in the board's report. Prior to the September Amendment, the Listing Agreement had substantially similar requirements10. However, the biggest contradiction was where the Act says that the tenure held as on 1st April, 2014 would not be counted towards determination of tenure. The Listing Agreement, however, stated that if an independent director has held tenure of five years or more as on 1st October, 2014, he shall be eligible for another term of five years only. In a move to maintain consistency, the September Amendment substituted Clause 49(II)(B)(3)(a) in its entirety. The new clause now says that the maximum tenure of independent directors shall be in accordance with the Act and clarifications/ circulars issued by MCA in this regard, from time to time.

Vide MCA Clarification, it is clarified that since the Act provides for a term of 'up to five consecutive years' for an independent director, it essentially signifies that independent directors may be appointed for a term of less than five years, which appointment however shall be construed as one term.

The Act11 further states that though an independent director shall not hold office for more than two consecutive terms, such independent director shall be eligible for reappointment after the expiration of three years of ceasing to become an independent director. A combined reading of this provision along with the MCA clarification settles the position that a person shall have to vacate office after two consecutive terms even if the total number of years of his appointment in such two consecutive terms is less than ten years. However, he shall be eligible for re-appointment after the expiry of the cooling-off period of three years.

Independent Directors: At a glance

A brief summary of the above mentioned requirements under the two statutes for public companies is as follows:

Serial No. Provision Act and Rules Listing Agreement
1. Applicability to kinds of companies Act is applicable to listed companies and Rules to some classes of public companies. Applicable to all listed companies, except the ones excluded by the September Amendment.
2. Criteria for independent directors Criteria listed under section 149 (5) of the Act and Rule 5. In addition to the criteria mentioned under the Act and the Rules, two additional criteria are prescribed.
3. Board composition Certain classes of public company (if they cater to the criteria laid down under the Rules) – at least two independent directors.

Listed company-at least one third of the board.
Where chairman of the board is a non-executive director at least one-third of the board.

Where the non-executive chairman is a promoter or is related to any promoter or person occupying management positions at the board or where the company does not have a regular non-executive Chairman- at least one half of the Board

Independent Directors under the committees

The Act and the Listing Agreement prescribe that the following committees shall have independent directors:

  1. Audit Committee: The Act12 states that every listed company and such other companies that may be prescribed shall have an audit committee which shall have minimum of three directors out of which majority shall be independent directors. The Listing Agreement on the other hand states that two-thirds of the members of audit committee shall be independent directors. The Listing Agreement further provides that the Chairman of the Audit Committee shall be an independent director.
  2. Nomination and Remuneration Committee- The Act13 states that every listed company and such other companies that may be prescribed shall have Nomination and Remuneration Committee which shall have minimum of three non-executive directors out of which not less than half shall be independent directors. The Listing Agreement imposes the same obligation but goes on to state that the Chairman of this committee has to be an independent director.

    In addition to listed companies, the following classes of companies are prescribed under the Companies (Meetings of Board and its Powers) Rules, 2014 which are mandated to constitute the Audit Committee and Nomination and Remuneration Committee:

    1. all public companies with a paid up capital of ten crore rupees or more;
    2. all public companies having turnover of one hundred crore rupees or more; and
    3. all public companies, having in aggregate, outstanding loans or borrowings or debentures or deposits exceeding fifty crore rupees or more.
  3. Corporate Social Responsibility Committee ("CSR") - The Act commands the following companies to havea Corporate Social Responsibility Committee which shall have minimum of three directors out of which at least one shall be an independent director.

    1. Having net worth of Rs. 500 crore or more, or
    2. Turnover of Rs. 1000 crore or more, or
    3. A net profit of Rs. 5 crore or more during any financial year.
    The Companies (Corporate Social Responsibility Policy) Rules, 2014 ("CSR Rules") provide certain supplementary clarifications. The CSR Rules state that in case of a private company having two directors, the committee can be constituted with only two directors. Further, unlisted public companies and private companies which adhere to the above mentioned criteria and which are not required to have independent directors on the board pursuant to section 149(4) of the Act (and the Rules), can have the CSR committee without independent directors.

Conclusion

The September Amendment has accorded minimal relief to listed companies with respect to the existing intersecting and stringent provisions. Considering the overlapping requirements under the Act and the Listing Agreement, much needed clarifications are required to ensure easy compliance. This clarification should be aimed at removing inconsistencies with respect to criteria for independent directors, board composition and composition for committees. SEBI and MCA must work hand in hand and ensure consistency under the statutes. In order to overcome the hurdles with respect to enforcement, SEBI and the MCA must take a liberal approach during the year, giving relaxations where possible and take a lenient view on inadvertent non-compliance during the first full year of applicability. The judicial decisions shall go a long way in removing ambiguity and providing the necessary clarity.

Footnotes

1. Vide circular no. CIR/CFD/POLICY CELL/2/2014

2. Vide circular no. CIR/CFD/POLICY CELL/7/2014

3. General Circular Number 14/2014 dated June 9th, 2014

4. Section 149 (7) of the Companies Act, 2013

5. Rule 5 of the Companies (Appointment and Qualification of Directors) Rules, 2014

6. Section 196 of the Companies Act, 2013.

7. Section 149 (4) of the Companies Act, 2013

8. Rule 4 of the Companies (Appointment and Qualification of Directors) Rules, 2014

9. Section 149(10) of the Companies Act, 2103

10. Clause 49(II)(B)(3)(a) of the Listing Agreement dated April 17th, 2014

11. Section 149 (11) of the Companies Act, 2013

12. Section 177 of the Companies Act, 2013

13. Section 178 of the Companies Act, 2013

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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