This article has been written by Nazmal Mohammed pursuing a Diploma in Corporate Law & Practice: Transactions, Governance and Disputes course from LawSikho.
This article has been edited and published by Shashwat Kaushik.
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Effective corporate governance is the key for any business enterprise, which needs to be driven by transparency, accountability, and the ethical behaviour of the management and the employees. The independent directors have a pivotal role to play in the company. They are tasked with the responsibility of delivering impartial oversight, safeguarding the interests of all stakeholders, and serving as a crucial check on the management’s actions.
Despite this noble role of independent directors, there are concerns raised, and allegations have been made that some of the independent directors are becoming mere puppets, manipulated by company promoters. This article undertakes an exploration of the controversy enveloping independent directors, shedding light on the potential vulnerabilities that may expose them to undue influence.
The Satyam scandal was an eye opener for the Government of India, and it sought to revamp the corporate regulatory framework. As part of these efforts, new legislation was enacted—the Companies Act of 2013. This legislative initiative aimed to reinforce corporate governance, address the challenges to the independence of the directors, strengthen the regulatory landscape for sustainable business practices and ensure that such scandals are not repeated.
Understanding independent directors
The role of independent directors is to exercise independence in everything they do. The composition of the board of directors is vital to the independent functioning of the board. There are primarily three types of directors in the company – which are executive directors, non-executive directors, and independent directors. The independent directors should function as a watchdog, custodian, whistleblower, representative, guide, coach and mentor to the company.
Independent directors, as a watchdog, should keep a check on corporate governance and various business risks. They should resist pressure from owners, take decisions in key appointments, manage conflicts, bring an objective view and ensure the interests of stakeholders are protected.
As the “custodian,” the sustainability of the company in matters of corporate governance, productivity, efficiencies, and many more sustainability factors must be guarded.
As the “whistle blower” and a non-executive director, the independent director should ensure “integrity, independence and effectiveness” in the company’s operations, business strategy and reporting arrangements, including an annual report to the board and ensure sufficient controls to exercise independence.
An independent director is a member of a board of directors who does not have a material relationship with a company and is neither part of its executive team nor involved in the day-to-day operations of the company but “represents” and safeguards the interests of all stakeholders, particularly the minority shareholders. An independent director should also act as a guide, coach, and mentor to the company. He should improve the corporate credibility and the governance standards.
Allegations : understanding the concerns
There have been many allegations of independent directors whose independence has been questioned. The argument is that the independent directors are more inclined to carry out the direction set by the company’s promoters rather than fulfilling their primary duties.
Appointments and composition
An allegation is that promoters might apply undue influence during the appointment process of independent directors. This results in forming the board with individuals who are inclined to favour the interests of the promoters over those of minority shareholders.
In most cases where the allegations are reported, independent directors have personal or financial ties with the promoters or their affiliates, although this is not explicit enough to disqualify them. These covert relationships are compromised and objectivity when making crucial decisions is lost. Hence, independence is not exercised.
Perks and remuneration
Some critics argue that independent directors might be enticed by lavish perks, director fees, or other financial incentives offered by the promoters. Such inducements can potentially influence their judgement and lead to conflicts of interest.
Fear of reprisals
Directors who challenge the decisions or actions of promoters risk facing retaliation, such as removal from the board or damaging their professional reputation. This fear of retribution can deter independent directors from acting independently.
Impact on corporate governance
The presence of puppet independent directors can have severe implications for corporate governance and the overall health of the company:
Puppet directors may fail to provide the necessary checks and balances, leading to unchecked management decisions and potential abuse of power. The consequences of unchecked management decisions can be far-reaching. Short-term gains may be prioritised at the expense of long-term sustainability, leading to financial instability and reputational damage. Risk management and compliance may be overlooked, exposing the organisation to legal and regulatory risks. Moreover, the erosion of trust among stakeholders, including shareholders, employees, and customers, can severely undermine the organisation’s ability to attract and retain talent, as well as secure investor confidence.
To mitigate these risks, organisations must prioritise the appointment of truly independent directors who possess the courage and integrity to question management decisions and provide effective oversight. These directors should have diverse backgrounds, skills, and experiences to bring a range of perspectives to the boardroom. Additionally, mechanisms for regular performance evaluations and accountability should be established to ensure that directors fulfil their fiduciary duties and act in the best interests of the organisation and its stakeholders.
Diminished investor confidence
Stakeholders, especially minority shareholders and institutional investors, may lose faith in the company’s governance practices, leading to a decline in investment.
There are a number of stakeholders who can be affected by diminished investor confidence. These include:
- Minority shareholders: Minority shareholders are individuals or groups who own a small percentage of a company’s stock. They are often less powerful than institutional investors, and they may be more vulnerable to losses if the company’s stock price declines.
- Institutional investors: Institutional investors are organisations that invest large sums of money on behalf of their clients. These include pension funds, mutual funds, and hedge funds. Institutional investors can have a significant impact on a company’s stock price, and they are more likely to sell their shares if they lose confidence in the company’s leadership and governance practices.
The consequences of diminished investor confidence
Diminished investor confidence can have a number of negative consequences for a company, including:
- A decline in the company’s stock price: When investors lose confidence in a company, they are less likely to buy its stock. This can lead to a decline in the company’s stock price, which can make it more difficult for the company to raise capital.
- An increase in the cost of capital: When investors are less confident in a company, they are more likely to demand a higher return on their investment. This can lead to an increase in the company’s cost of capital, which can make it more difficult for the company to fund its operations.
- A loss of credibility: When investors lose confidence in a company, they are less likely to believe what the company’s leaders say. This can make it difficult for the company to attract and retain top talent, and it can also damage the company’s reputation.
Recommendations for companies
There are a number of things that companies can do to address diminished investor confidence, including:
Improving corporate governance practices: Companies should ensure that their corporate governance practices are transparent, fair, and accountable. This includes having a strong board of directors, independent auditors, and a clear code of conduct.
Communicating regularly with investors: Companies should communicate regularly with investors to keep them informed about the company’s performance and its plans for the future. This can help to build trust and confidence among investors.
Erosion of transparency
The lack of independent oversight can hinder the transparency of decision-making processes, making it difficult for stakeholders to evaluate the company’s performance objectively. Independent oversight serves as a critical safeguard for maintaining transparency in decision-making processes. Independent oversight bodies, such as audit committees, independent directors, or external watchdogs, provide an objective perspective and help ensure that decisions are made based on merit, without undue influence or hidden agendas.
In the absence of independent oversight, decision-making processes can become opaque and susceptible to manipulation. Stakeholders may find it challenging to assess the rationale behind decisions, leading to scepticism and reduced trust in the organisation’s leadership. Without independent scrutiny, there is an increased risk of conflicts of interest, favouritism, and unethical behaviour going unnoticed or unaddressed.
Case 1- Kingfisher Airlines Limited (2012)
In 2006, Deccan Aviation Limited, promoted by Captain G.R. Gopinath, came out with an IPO at a hefty price of Rs. 148 per share. After a few months in 2007, Captain Gopinath sold the controlling stake in this company to Vijay Mallaya, who was running an unlisted company, Kingfisher Airlines Limited.
Eventually, the company promoted by Captain Gopinath lost its existence within a period of one year and got merged into Kingfisher Airlines Limited. Kingfisher had already stopped its operations a long time ago, and the investment made by the public became zero even before Vijay Mallaya left the country. There is no recourse available to them to recover their lost money. Unfortunately, this is not an isolated case.
Case 2- IL&FS (Infrastructure Leasing and Financial Services) Crisis (2018)
In the case of IL&FS, independent directors were questioned for not exercising due diligence in overseeing the financial health of the company. The crisis revealed significant governance lapses, and some independent directors were accused of not fulfilling their fiduciary duties.
The crisis highlighted significant lapses in governance, including inadequate risk management, a lack of transparency, and weak internal controls. Independent directors are expected to be financially literate, possess industry knowledge, and act with prudence and independence. However, in the case of IL&FS, some independent directors were alleged to have failed to fulfil their fiduciary duties, resulting in the company’s downfall.
The aftermath of the IL&FS debacle has led to increased scrutiny of independent directors and calls for reforms to strengthen their role. Regulators and policymakers have taken steps to enhance corporate governance practices, including increasing the accountability and responsibility of independent directors. This includes mandating regular training, enhancing disclosure requirements, and promoting greater diversity on boards.
Additionally, independent directors must be able to exercise independent judgement and resist undue influence from dominant shareholders or management. To achieve this, they should have access to information, resources, and support to enable them to effectively discharge their duties.
Case 3- PNB Fraud (2018)
The Punjab National Bank (PNB) fraud involving Nirav Modi raised concerns about the role of independent directors in preventing fraudulent activities. Some independent directors were criticised for not questioning the irregularities in the bank’s operations.
Several independent directors on the board of PNB were criticised for allegedly failing to exercise due diligence and raise questions about irregularities in the bank’s operations. The criticism stemmed from the fact that, despite their fiduciary responsibilities, some independent directors seemingly overlooked or ignored red flags that could have potentially prevented or detected the fraudulent activities.
Critics argued that independent directors have a crucial role in providing independent oversight and monitoring the actions of executive management. They are expected to exercise independent judgement, ask tough questions, and challenge any suspicious or unethical practices. However, in the case of PNB, it appeared that some independent directors may have fallen short in fulfilling their duties, leading to a sense of disappointment and loss of trust among stakeholders.
The PNB fraud highlighted the need for strengthening the role and independence of non-executive directors. Calls were made for reforms to enhance the effectiveness of corporate governance mechanisms and ensure that independent directors possess the necessary skills, experience, and independence to effectively scrutinise the actions of management and protect the interests of shareholders and depositors.
Addressing the concerns
To counter the puppetry allegations, several measures can be implemented:
- Enhanced disclosure: Companies should disclose the rationale behind the appointment of independent directors and any potential relationships they may have with promoters or affiliates.
- Diverse board composition: Diversifying the board by including independent directors from varied backgrounds can help prevent a homogeneous decision-making environment.
- Robust evaluation process: Regular performance evaluations of independent directors, along with strict criteria for independence, can help identify any potential conflicts of interest.
- Protection for independent directors: Whistleblower protection and indemnity provisions can provide independent directors with the confidence to voice concerns without fear of reprisal.
Controls : regulatory provisions
With regards to the appointment of independent directors, the Companies Act, 2013 provides a list of persons who are related to and have an interest in company affairs, disqualifying them from being appointed as independent directors over certain limits. The appointment of independent directors requires the board’s approval. They can serve for five consecutive years. Reappointment for another five years is possible by passing a special resolution in a general meeting.
Under Section 149(7), independent directors must declare their independence status at their first board meeting, recurring the same in the first meeting in each financial year, and whenever any such circumstances arise that may affect their independence as a director.
The role and functions of independent directors are largely governed by the Companies Act, 2013, the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 and recently, through the SEBI (Listing Obligations and Disclosure Requirements) (Amendment) Regulations, 2018.
Accordingly, for a listed company where the Chairperson of the Board of Directors is a non-executive director, the Board of Directors shall comprise of independent directors at least one-third of total directors and where the listed entity does not have a regular non-executive Chairperson, a minimum of half of the Board of Directors shall comprise of independent directors.
SEBI mandated that the Board of Directors of the listed entities shall have at least one independent female director and at least one independent female director.
The goal of good corporate governance and safeguarding the interests of all stakeholders is in the hands of independent directors. Although there are instances of unethical practices or conflicts of interest, it is not correct to assume that all independent directors act as puppets. Such allegations emphasise the requirement for greater commitment and transparency in the appointment and functioning of independent directors.
By enhancing disclosure practices and encouraging a culture of independence, companies can work towards being impartial custodians of corporate governance rather than mere puppets in the hands of promoters.
There is a high need for the government to understand that they should protect honest, independent directors. Only when the independent directors believe they are protected under the law will they be able to perform their functions diligently and exercise their authority efficiently.