This article has been written by Kaushiki Vatsa, pursuing a Diploma in Advanced Contract Drafting, Negotiation and Dispute Resolution from LawSikho. This article has been edited by Ruchika Mohapatra (Associate, Lawsikho).
The concept of Independent directors cannot in any way be considered as a newly discovered concept but there have been such remarkable developments in this concept over a few years that it is now seen in a certain new light. Moreover, this concept has been a consistent topic of debate after the popular scams such as the Satyam case. The Independent directors have been brought with the objective that they will enhance the objectivity of corporate governance throughout the corporate world. There are a number of different pieces of evidence which brought a mixed result in the effectiveness of independent directors. The aim of this paper is to trace back the independent directorship to its evolution and to find out whether they are as independent as they pretend to be. To achieve this, the theoretical concepts about the different models of corporate governance and the origin of the concept of independent directors will be briefly discussed.
Concept of independent directors
In practical terms, the origin of the concept of Independent directors can be traced back to the 1950s US. This was the time when certain people that were not employees of the company or were not connected with the company were selected so that they could be part of the board of directors.
Two models of corporate governance
There are two models of corporate governance, the outsider and the insider model. Countries like the US and UK have incorporated the outsider model. The main objective of the outsider model of corporate governance is to protect the shareholders from being exploited by the management. There is a lowkey understanding that the shareholders are dispersed (Shareholder Primacy theory) and the concept of independent directors has been linked to this theory. From this, we can conclude that the concept of Independent directors was discovered as a way to protect these dispersed shareholders from the management of the company.
The insider model of corporate governance, which is applicable in countries like India and China, works in a totally different way. In this model, the company is controlled by the individuals who develop a relationship with the company, usually a long-term relationship. These individuals are also referred to as “insiders” and they are mostly from the same family. These “business families” control the company by owning the majority of the shares and unlike the previous agency problem, here, the problem is between the majority shareholders and minority shareholders. Because of this, these families enjoy huge power and mould every decision of the company in such a way that it can benefit them.
In the following circumstances, the work of the independent directors should have been to protect the minority shareholder from the majority shareholders but this is not what happens. The concept of independent directors is directly copy-pasted, in a very literal sense, from the outsider model and thus, the Independent directors find themselves confused as there is no concrete law that can be useful in guiding them.
Independent directors in India
In India, liberalisation led to the development of corporate governance which further led to the introduction of the concept of independent directors. It is important to note that the only way Independent directors can work efficiently is when they are free from the influence of the management of the company. But there is an inherent problem in this due to the fact that the concept is directly imported from the outsider model and is being implemented in the insider model with zero modifications.
There have been several principles of corporate governance that have been transplanted to India from the US or UK because of the fact that these jurisdictions have a common law background. But in this scenario, there is a difference between the objective of their model of corporate governance with ours, as well as different agency problems. As a result of the aforementioned reasons, there exists a lot of vagueness and arbitrariness. India has a system where the shareholders owning the majority of the shares control everything. Therefore, the independent directors should have additional responsibilities such as preventing the exploitation of the majority shareholder from the dominant shareholders and preventing “insider” problems in the company. Hence, the Independent directors should be able to act in this dual way.
It is also important to highlight the fact that there have been several modifications or several attempts in the Companies Act so that the independent directors can achieve their independence in a literal way. For example, for the appointment of independent directors, there is a well-described procedure (Appointment and qualification of directors) rule- which states that the appointment of independent directors can be objected to by all the members. But this provision does not ensure that the Independent directors are free from the influence of the management or the shareholders owning the majority of the shares.
Problems faced by the independent directors in India
After the Satyam case, the independent directors were put under a lot of scrutinies. This further resulted in the exodus of around 620 Independent directors. According to Section 149 (12) of the Companies Act, there is a requirement that the Independent Directors should act as a strategic advisor as well as a watchdog. This creates a lot of confusion as the more the Independent directors are outside, the less is their will to maximize the company’s profit and the more they are “inside”, the less independence they get. What is interesting to note here is that in an interview-based study, it was observed that the independent directors perceive themselves as strategic advisors and not as watchdogs. The reason behind this is because as watchdogs, they have more liability and there is more scope of the damage to their reputation. This leads us to two conclusions- firstly, the Independent directors are not encouraged to monitor the management of the company and secondly, even if some Independent directors are, they do not have the necessary tool, mechanism, independence and information (except the audit committee) to monitor them.
Steps to be taken to remedy the problem
The only way to ensure the independence of the Independent directors is to prevent the shareholder and the management of the company from having influence over the selection process of the independent directors. And therefore, the Nomination and Remuneration Committee, which is appointed by the Board, is an insignificant and insufficient mechanism as this committee is independent only in papers because of the fact that it is appointed by the board members according to Section 178(1) of the Companies Act.
SEBI should make laws and policies that could be used as a mechanism to supervise Independent directors and should not only focus on imposing liabilities on independent directors. Another way to prevent this problem is the introduction of Independent Supervisors, appointed by the body which is entirely different from the company. They will have a better chance to fulfil some of the insufficiencies of the independent directors. Moreover, it will be useful when the independent supervisors will have the power to appoint directors.
Another way to supervise and monitor Independent directors can be done by a national level supervisory board of Independent directors. This will be a completely independent board that will establish a literally separate mechanism to monitor the management of the company. Moreover, this will provide a mechanism by which the independent directors will be able to act as strategic advisors whereas the board will ensure a system of checks and balances.
The concept of Independent directors was introduced in India with the objective that they will play a major role in enhancing the standards of corporate governance and will also be successful in ensuring that the companies are run in a more transparent way This paper provides a brief understanding of the origin of the Independent directors in India and the difficulties or the arbitrariness they face because of the inherent problems of being directly transplanted to India from a different type of corporate governance, without any modifications. The independent directors are not able to work properly because of the lack of emphasis given to the Indian legal system and the different types of corporate governance that it has. One of the alternative options that might be quite useful is the Delaware Model, where independence is decided by observing the behaviour of the directors and is not taken for granted, as a status.
- Jeffery N. Gordon, ‘The Rise of Independent Directors in the United States, 1950-2005: Of Shareholder Value and Stock Market Price.’ (2007)
- Markus Berndt, ‘Global Differences in Corporate Governance Systems Theory and implications for reforms.’ (2000)
- Cydney Posner,’ So long to Shareholder Primacy.’ (2019)
- Umakanth Verotill, ‘Evolution and Effectiveness of Independent directors in Indian Corporate Governance.’ (2010)
- Victor Brudney, ‘The Independent Director: Heavenly City or Potemkin Village?’ (1982)
- Shen and Jia, ‘Will the Independent Directors Work in China?’ (2005)
- Vikramaditya Khanna and Shaun J. Mathew, ‘The Role of Independent Directors in Controlled Firms in India: Preliminary Interview Evidencer’ (2010)
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