This article was written by Hemang Mohanlal Doshi, pursuing the Personal Branding Program for Corporate Leaders Course from Skill Arbitrage, and edited by Koushik Chittella.
Table of Contents
Introduction
To begin, why do we need independent directors in the boardroom first of all?
To promote and support the four “P” pillars of corporate governance, i.e., people, purpose, performance, and process, companies should focus on basic principles of accountability, responsibility, transparency, and fairness to ensure and safeguard the interests of various stakeholders and promoters. So, having independent directors in the boardroom and discussions brings unbiased objectivity in the decision-making process, thus improving transparency and accountability. Further, independent directors, who meet the “independent criteria,” improve the overall governance and management of the company with greater responsibility.
In India, the appointment of independent directors is a mandate by the Companies Act, 2013, and SEBI LODR (Listing Obligations and Disclosure Requirements) Regulations, 2015. These regulatory bodies have laid out the eligibility criteria, selection process, tenure, and responsibilities for independent directors. Also, industry experts and professional organisations like the Institute of Directors (IOD) have detailed industry best practices and guidelines on the appointment of independent directors to ensure good corporate governance.
Current procedure for appointment of independent directors
Eligibility criteria
The Companies Act, 2013 has laid down eligibility criteria for selection of independent directors, but the primary focus is on “independent criteria,” maintaining a true arm’s-length distance from company directors and executives.
Key Criteria as detailed out in the Companies Act, 2013:
- Person of integrity with experience and expertise as specified by BOD.
- Hold no pecuniary relation with the promoters or the directors or has no more than
10% of transactions from total annual income from the company.
- Himself or relatives does not hold 2% or more of share capital (at face value), including subsidiaries or given guarantees to 3rd parties.
- Relatives do not hold any KMP position in the company.
- Does not hold 2% or more of total voting power in the company along with relatives.
- Is not a CEO or director of any non-profit company that receives 25% or more of its
grant from the company.
Key trends
Following checks are done to ensure and maintain the integrity of the board.
- The person has held or is holding any senior management position in the last 3 years.
- Hold substantial shares of any company.
Selection process
The Nomination and Remuneration Committee plays a vital role in the selection process of the independent director. NRC can get recommendations from the board , external consultants, or databases of qualified professionals (IICA) of eligible candidates based on the eligibility criteria, experience, expertise, skills, and independence of the independent director.
Recommendation from RedLaw: RedLaw recommends conducting candidate interviews and background checks to identify candidates who can contribute efficiently and effectively to the board and company’s corporate governance. These recommendations are in addition to the internal assessments that the company may conduct to test the candidates.
Nomination and appointment
Shortlisted candidates by the NRC committee are proposed to the board for review and approval. After subsequent approval from the board, the candidates are proposed for approval in the next general meeting by shareholders. The shareholders may ratify or ask for clarification or even rejection as a majority vote. If approved in the general meeting, candidates are offered appointment letters and onboarding plans. A written consent is solicited from the candidates to act as independent directors. This consent is then filed with the Registrar of Companies (RoC). As per the current trends, every appointed independent director needs to have DIN (Director Identification Number) and DSC (Digital Signatures Certificate) as a part of the appointment process.
Recommendation from PWC: For better transparency, clear documentation is done for the processes, right from selection criteria, reasons for approval of candidates, and any conflict of interest for rejected candidates. This process helps to strengthen the integrity of the appointment of independent directors.
Disclosure and consent
As per the Companies Act, 2013, independent directors are required to submit declarations of independence annually. This means the declaration of independence has to be renewed every year. Also, companies are required to disclose this declaration in annual reports.
Best practices prescribed by the Companies Act, 2013 and SEBI (LODR) Regulations, 2015
The Companies Act, 2013 states that an independent director does not have a pecuniary relationship with the company or its promoters and management, apart from receiving financial remuneration committed by the company as sitting fees. Even the Act prohibits stock options receivables by the independent directors. This helps to maintain high ethical standards and integrity of the directors to ensure best interests of the company and all stakeholders is maintained without any external influences
Recommendation from CII: The Confederation of Indian Industry (CII) recommends strict vigilance of the independent directors to ensure that independence criteria of directors is not compromised or threatened under any circumstances. Objectivity in decision-making is ensured and not influenced in any way.
Role and responsibilities
Independent directors have a broad range of responsibilities besides safeguarding the interests of minority shareholders, the integrity of financial statements, and the risk management of the company. Independent directors have to maintain a high level of ethical standards and comply with regulation. They have to champion the audit committee for any irregularities, frauds and misstatements.
Recommendation from PWC: As sustainability and corporate social responsibility (CSR) initiatives are gaining importance and popularity, independent directors should equally prioritise those initiatives.
Tenure and rotation
The Companies Act, 2013 has set a maximum of two tenures of 5 years for an independent director consecutively. A cooling-off period of three years is required before the director can be considered and reappointed. This regulation helps to maintain the independence of the director and avoid any entrenchment into the company.
Recommendation from RedLaw: The rotation policy helps to maintain boardroom dynamics and innovative thinking as new talent keeps joining the team periodically.
Performance evaluation
The Companies Act, 2013 mandates that boards have to evaluate the performance of independent directors regularly. This mandate requires that evaluation should consider factors such as attendance at meetings, participation in discussions, and the ability to provide strategic guidance and improvements. These evaluations help to ensure that independent directors are performing effectively and adding value to the company.
Recommendation from CII: A well-structured evaluation of independent directors provides detailed insights of the overall effectiveness and highlights areas of improvement for the independent directors.
Composition of the board
The LODR, 2015 regulations mandate that at least one-third of the board of directors should be independent directors. If the chairman is a non-executive director, then at least half of the board should be independent. This composition helps to ensure that independent directors bring objectivity and unbias in decision-making, protecting the interests of minority stakeholders.
Role of audit committees
The audit committee, an important part of corporate governance, must have at least two-thirds independent directors under the LODR regulations. Independent directors on the audit committee help in maintaining the integrity of financial statements and the efficacy of internal controls by rigorous and unbiased scrutiny at all levels of the audit.
Related party transactions
The LODR, 2015 regulations mandate that all related party transactions must be approved by the audit committee, which has at least two-thirds independent directors. This composition ensures that transactions are conducted fairly and in the best interest of the company.
Global best practices for the appointment of independent directors
The UK Corporate Governance guidelines
The UK Corporate Governance Code places significant emphasis on transparency and accountability by independent directors in good corporate governance. The code further emphasises that the nomination committee should lead the selection process rigorously and ensure transparency in the process.
Key features are in the below table:
| Aspect | Details |
| Role and Responsibilities | – Objective scrutiny of decisions in risk, finance, and remuneration areas.-wherever possible, constructively challenge and support decisions and all executives.- Primarily protect shareholder interests. |
| Board Composition | – For large companies, at least half of the board (excluding the chair) should be independent non-executive directors.- Smaller companies, at least two independent directors. |
| Nomination Committee | Primarily made up of independent directors. The chairman can be an independent director. |
| Remuneration Committee | To ensure executive pay aligns with performance and shareholder interest, this committee should be solemnly composed of independent directors. |
| Tenure of Independent Directors | To maintain independence and bring fresh perspectives and innovation, independent directors should usually serve nine years maximum. |
U.S. SEC guidelines
In the United States, the Securities and Exchange Commission (SEC) requires listed companies to have a majority of independent directors on their boards to ensure unbiased decision-making in critical areas.
Key features are in the below table:
| Aspect | Details |
| Role and Responsibilities | 1. Champion and scrutinise financial reporting, risk management, and compliance.2. Manage all conflicts of interest in the company’s decisions. |
| Board Composition Requirements (SOX Act) | As per SOX, public companies must have a majority of independent directors, with certain committees fully independent. |
| Audit Committee | The Audit Committee must consist of independent directors only and have at least one financial expert. |
| Remuneration and Nomination Committees | Remuneration and Nomination Committees must be composed entirely or mostly of independent directors. |
| Dual Role of CEO and Chairman | SEC requires separate roles of CEO and Chairman for stronger independence; if not, companies must explain the reasons. |
| Limits on Tenure | No specific tenure limits, but any compromise on independence should be avoided. |
Trends in other countries
Other countries like Australia and Singapore have emphasised diverse board compositions to enhance board effectiveness and decision-making. More emphasis is on independence criteria to promote good corporate governance.
Challenges and pitfalls in the appointment process
Conflict of interest
This is the major challenge, as independent directors have past associations with the companies, promoters, and management. While companies prefer to appoint independent directors from known circles, objectivity of independence is compromised most of the time.
Vigilance and disclosure of any kind of relationship is essential to maintain this compliance with LODR, 2015, and the Companies Act, 2013.
Lack of due diligence
This is the second challenge, as due diligence is needed in the selection process of the independent directors. Most of the companies appoint directors based on connections and reputation instead of rigorous assessment. This leads to the appointment of individuals who lack the necessary skills or independence, which hampers the boards performance and effectiveness.
Overloading and time commitments
Many times independent directors get onboarded on multiple committees and are overloaded. This causes time crunch and attention, which results in poor performance affecting the effectiveness of the board and independent directors. It should be ensured that independent directors have sufficient time and resources to fulfil their duties as expected.
Suggestions
With the advent of technology and continued usage of software programs in automation, companies are expected to undergo changes wherein AI systems will be part of the board. Therefore, AI systems should be acting as an independent director mandatorily on the board. AI systems, with their vast data processing and analytical capabilities, can help generate accurate financial statements and error-free reports. Since the data used to train AI or biases in AI algorithms can influence the output of the reports, it is recommended that AI systems should always work in human collaboration to avail the maximum benefits and effectiveness. This new shift towards AI systems will increase the trust of stakeholders and shareholders by promoting good corporate governance, as decision-making will move from opaque traditional methods to more transparent, data-driven approaches.
Conclusion
In conclusion, this article covers all the procedures required from the Companies Act, 2013 and LODR, 2015 for appointing an independent director from a regulation standpoint. Further, all the best practices around the globe are discussed with key recommendations from industry experts and professional organisations.
References
- https://www.linkedin.com/pulse/appointment-selection-process-independent-directors-india-nelson-vnckc
- https://redlaw.in/procedure-for-appointment-of-independent-director/
- https://www.pwc.com/mu/en/publications/miod-best-practices-guidelines-for-appointment-of-directors.html
- https://www.cii.in/PressreleasesDetail.aspx?enc=5QQ58n/9mYNnVCJtQQduIRGKsMYO1LrwasHU7mlFgsA=
- https://www.iodglobal.com/about-us
- https://www.mca.gov.in/Ministry/reportonexpertcommitte/chapter4.html
- https://www.frc.org.uk/library/standards-codes-policy/corporate-governance/uk-corporate-governance-code/
- https://www.sec.gov/rules-regulations
- https://www.sebi.gov.in/legal/regulations/sep-2023/securities-and-exchange-board-of-india-listing-obligations-and-disclosure-requirements-regulations-2015-last-amended-on-september-20-2023-_77239.html
