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Naresh Chandra Committee Report on Corporate Governance
Executive Summary Part: 3

Recommendations from Chapter 4: Independent Directors

At the core of corporate governance is the board of directors. A joint-stock company is owned by the shareholders, who appoint a board of directors to supervise management and ensure that it does all that is necessary by legal and ethical means to expand the business and maximise long-term corporate value.

The first point to note is the one that is frequently forgotten: the board is appointed by the shareholders and other key stakeholders. Simply put, directors are fiduciaries of shareholders, not of the management. This does not imply that the board must have an adversarial relationship with the management. However, in instances where the objectives of management differ from those of the wide body of shareholders, the non-executive directors on the board must be able to speak in the interest of the ultimate owners, discharge their fiduciary oversight functions; in short, they should stand up and be counted. This is why 'independence' has become such a critical issue in determining the composition of any board. Clearly, a board packed by executive directors, or friends of the promoter or CEO, can hardly be expected to exercise independent oversight judgement.

After going through various international best-in-class definitions of independence, and keeping in mind pragmatic factors, the Committee came to the conclusion that the definition can be made more precise than what is contained in Clause 49 of the Listing Agreement without compromising the spirit or constraining the supply of independent directors.

Defining an independent director (Recommendation 4.1)

An independent director of a company is a non-executive director who:

  1. Apart from receiving director's remuneration, does not have any material pecuniary relationships or transactions with the company, its promoters, its senior management or its holding company, its subsidiaries and associated companies;

  2. Is not related to promoters or management at the board level, or one level below the board (spouse and dependent, parents, children or siblings);

  3. Has not been an executive of the company in the last three years;

  4. Is not a partner or an executive of the statutory auditing firm, the internal audit firm that are associated with the company, and has not been a partner or an executive of any such firm for the last three years. This will also apply to legal firm(s) and consulting firm(s) that have a material association with the entity

  5. Is not a significant supplier, vendor or customer of the company;

  6. Is not a substantial shareholder of the company, i.e. owning 2 per cent or more of the block of voting shares;>

  7. Has not been a director, independent or otherwise, of the company for more than three terms of three years each (not exceeding nine years in any case);

An employee, executive director or nominee of any bank, financial institution, corporations or trustees of debenture and bond holders, who is normally called a 'nominee director' will be excluded from the pool of directors in the determination of the number of independent directors. In other words, such a director will not feature either in the numerator or the denominator. · Moreover, if an executive in, say, Company X becomes an non-executive director in another Company Y, while another executive of Company Y becomes a non-executive director in Company X, then neither will be treated as an independent director.

The Committee recommends that the above criteria be made applicable for all listed companies, as well as unlisted public limited companies with a paid paid-up share capital and free reserves of Rs.10 crore and above or turnover of Rs.50 crore and above with effect from the financial year beginning 2003.

The Committee felt that to be really effective, independent directors need to have a substantial voice, by being in a majority. It was felt that rather than the management or the promoters, the Committee should put its weight behind minority shareholders and other stakeholders such as consumer or creditors. The committee, therefore recommends felt that independent directors must also have adequate presence and strength on the Board, especially of the cCompanies that are listed or, being public companies above a specific size.

Percentage of independent directors (Recommendation 4.2)

No less than 50 per cent of the board of directors of any listed company, as well as unlisted public limited companies with a paid-up share capital and free reserves of Rs.10 crore and above, or turnover of Rs.50 crore and above, should consist of independent directors - independence being defined in Recommendation 4.1 above. However, this will not apply to: (1) unlisted public companies, which have no more than 50 shareholders and which are without debt of any kind from the public, banks, or financial institutions, as long as they do not change their character, (2) unlisted subsidiaries of listed companies.

Nominee directors will be excluded both from the numerator and the denominator.

Since Corporate governance norms require companies to have a number of committees., Boards of listed and large unlisted public limited companies also have greater fiduciary responsibilities. For these reasons, the committee felt that the law should prescribe a minimum board size as well.

Minimum board size of listed companies (Recommendation 4.3)

The minimum board size of all listed companies, as well as unlisted public limited companies with a paid paid-up share capital and free reserves of Rs.10 crore and above, or turnover of Rs.50 crore and above should be seven - of which at least four should be independent directors. However, this will not apply to: (1) unlisted public companies, which have no more than 50 shareholders and which are without debt of any kind from the public, banks, or financial institutions, as long as they do not change their character, (2) unlisted subsidiaries of listed companies.

The Boards, and their committees, should not merely have meetings pro forma prior to a nice lunch. The shareholders have a right to know how much time the Board and its committees spent in discussing the shareholders' interest. The committee, therefore, recommends that duration of Board/committee meetings be disclosed.

Disclosure on duration of board meetings / Committee meetings (Recommendation 4.4)

The minutes of board meetings and Audit Committee meetings of all listed companies, as well as unlisted public limited companies with a paid paid-up share capital and free reserves of Rs.10 crore and above or turnover of Rs.50 crore must disclose the timing and duration of each such meeting, in addition to the date and members in attendance.

The Committee feels that the quality of Board meetings is enhanced with a fuller attendance. Since there are technological means available to do so, the Committee suggests that increased presence of members of the Board be encouraged through tele and video conferencing, subject to certain safeguards. This might also reduce cost of Board/Committee meetings to the company.

Tele-conferencing and video conferencing (Recommendation 4.5)

If a director cannot be physically present but wants to participate in the proceedings of the board and its committees, then a minuted and signed proceedings of a tele-conference or video conference should constitute proof of his or her participation. Accordingly, this should be treated as presence in the meeting(s). However, minutes of all such meetings should be signed and confirmed by the director/s who has/have attended the meeting through video conferencing.

The Committee noted that both the 1997 Report of the Working Group on the Companies Act, and clause 49 of listing agreement list out, adequately, the information that must be placed before the board of directors. To ensure that asymmetry of information for stakeholders, especially shareholders, is not further enhanced/reduced, the committee recommends

Additional disclosure to directors (Recommendation 4.6)

In addition to the disclosures specified in Clause 49 under 'Information to be placed before the board of directors', all listed companies, as well as unlisted public limited companies with a paid paid-up share capital and free reserves of Rs.10 crore and above, or turnover of Rs.50 crore and above, should transmit all press releases and presentation to analysts to all board members. This will further help in keeping independent directors informed of how the company is projecting itself to the general public as well as a body of informed investors.

If audit committees are indeed to be independent, they should really consist of only independent directors. There were doubts on the advisability of excluding nominee directors of financial institutions from audit committees. The Committee preferred to be consistent in not considering directors with a certain mandate to be really independent.

Independent directors on Audit Committees of listed companies (Recommendation 4.7)

Audit Committees of all listed companies, as well as unlisted public limited companies with a paid- up share capital and free reserves of Rs.10 crore and above, or turnover of Rs.50 crore and above, should consist exclusively of independent directors, as defined in Recommendation 4.1.

However, this will not apply to: (1) unlisted public companies, which have no more than 50 shareholders and which are without debt of any kind from the public, banks, or financial institutions, as long as they do not change their character, (2) unlisted subsidiaries of listed companies.

The committee has recommended that the role and functions that an audit committee is supposed to discharge in a company is clearly laid out in an audit committee charter.

Audit Committee charter (Recommendation 4.8)

In addition to disclosing the names of members of the Audit Committee and the dates and frequency of meetings, the Chairman of the Audit Committee must annually certify whether and to what extent each of the functions listed in the Audit Committee Charter were discharged in the course of the year. This will serve as the Committee's 'action taken report' to the shareholders.· This disclosure shall also give a succinct but accurate report of the tasks performed by the Audit Committee, which would include, among others, the Audit Committee's views on the adequacy of internal control systems, perceptions of risks and, in the event of any qualifications, why the Audit Committee accepted and recommended the financial statements with qualifications. The statement should also certify whether the Audit Committee met with the statutory and internal auditors of the company without the presence of management, and whether such meetings revealed materially significant issues or risks.

The maximum sitting fee permitted by the DCA is Rs.5,000. The committee was repeatedly reminded that peanuts fetch monkeys. The Committee believes that companies cannot hope to get the best talent unless they make it worthwhile for professionals to extend their time and expertise. The committee was cautioned that far too much payment may itself impair independence, just as over-reliance on a single client compromises the independence of auditors. However, the committee felt that advantages of adequate remuneration require government to review the position.

Remuneration of non-executive directors (Recommendation 4.9)

The statutory limit on sitting fees should be reviewed, although ideally it should be a matter to be resolved between the management and the shareholders.

In addition, loss-making companies should be permitted by the DCA to pay special fees to any independent director, subject to reasonable caps, in order to attract the best restructuring and strategic talents to the boards of such companies.

The present provisions relating to stock options, and to the 1 per cent commission on net profits, is adequate and does not, at present, need any revision. However, the vesting schedule of stock options should be staggered over at least three years, so as to align the independent and executive directors, as well as managers two levels below the Board, with the long- term profitability and value of the company.

Not even the most stringent international tenet of corporate governance and oversight assumes that an independent director - who interfaces with the management for no more than two days every quarter - will be in the know of every technical infringement committed by the management of a company in its normal course of activity. Indeed, making independent board members criminally liable for such infringements is akin to assuming that they are no different from executive directors and the management of a company. This is certainly not so. In fact, the principle is quite the opposite: independent directors are not managers; they are fiduciaries who perform wider oversight functions over management and executive directors.

At a more practical level, the Committee is of the opinion that it would be very difficult to attract high quality independent directors on the boards of Indian companies if they have to constantly worry about serious criminal liabilities under different Acts.

Exempting non-executive directors from certain liabilities (Recommendation 4.10)

Time has come to insert provisions in the definitions chapter of certain Acts to specifically exempt non-executive and independent directors from such criminal and civil liabilities. An illustrative list of these Acts are the Companies Act, Negotiable Instruments Act, Provident Fund Act, ESI Act, Factories Act, Industrial Disputes Act and the Electricity Supply Act.

Independent directors should also be indemnified, as outlined in paragraph 4.54 of the report, from costs of litigation etc

A professional may give excellent corporate advice that maximises long-term shareholder value, but may not be aware of the rights, responsibilities, duties and liabilities of a legal, recognised fiduciary. Understanding such issues requires training. The Committee feels that if companies can afford to compensate their independent directors well, then they should be able to provide them with good training too. DCA has a special role in encouraging and promoting training programmes in leading Indian institutions such as the Indian Institutes of Management, and in the Centre for Corporate Governance that they intend to set up.

Training of independent directors (Recommendation 4.11)

DCA should encourage institutions of prominence including their proposed Centre for Corporate Excellence to have regular training programmes for independent directors. In framing the programmes, and for other preparatory work, funding could possibly come from the IEPF.

All independent directors should be required to attend at least one such training course before assuming responsibilities as an independent director, or, considering that enough programmes might not be available in the initial years, within one year of becoming an independent director. An untrained independent director should be disqualified under section 274(1)(g) of the Companies Act, 1956 after being given reasonable notice.

Considering that enough training institutions and programmes might not be available in the initial years, this requirement may be introduced in a phased manner, so that the larger listed companies are covered first.

The executing bodies must clearly state their plan for the year and their funding should be directly proportionate to the extent to which they execute such plans.

There should be a 'trainee appraisal' system to judge the quality of the programme and so help decide, in the second round, which agencies should be given a greater role and which should be dropped



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