Directors Compensation – Past, present and Future? - MMJC

Provisions of Section 149, 197, and Schedule V of the Companies Act, 2013 (‘the Act’) deal with remuneration of Directors of the Company. Since the time Companies Act 1956 got replaced with Companies Act 2013, situation has been very dynamic as there have been as good as 20 changes in Section 197, Schedule V and the Companies (Appointment and Remuneration of Managerial Personnel) Rules, 2014 put together. Gone are the days when remuneration to managerial persons was tightly regulated. Since 2015, there have been series of changes in this space which indicates change in approach towards managerial remuneration. Self-governance is becoming a mantra! Continuing with the similar trend provisions are undergoing change in the Companies Amendment Act 2020.

However, before we discuss the changes happened in Section 197 in the Companies Amendment Act 2020, lets understand what was the situation before that amendment.

After the Companies Amendment Act 2017 (but before 2020 amendment) following was the situation:

Remuneration to Managing Director / whole-time director / Manager could be paid beyond the ceiling of 5% or 10% limits without going to Central Government subject to following conditions –

• Director should not be disqualified under Section 164 or under Part I of Schedule V of Companies Act 2013
• Approval of Nomination and Remuneration Committee should have been obtained while taking into account, financial position of the company, trend in the industry, appointee’s qualification, experience, past performance, past remuneration, etc.; and should be in a position to bring about objectivity in determining the remuneration package while striking a balance between the interest of the company and the shareholders.
• There should not be any default in payment of dues to any Bank / Public Financial Institution (PFI) / non-convertible debenture (NCD) holders or any other secured creditor. In case of default, the prior approval of the Bank or PFI concerned or the NCD holders or other secured creditor, as the case may be, shall be obtained by the company before obtaining the approval in the general meeting.
• Approval of Shareholders should be obtained by passing Special Resolution
• Explanatory Statement sent to shareholders at the time of seeking approval should contain all the requisite disclosures as prescribed under clause (iv) of second proviso to Section II of Part II of Schedule V of the Act.

Whereas following were the conditions applicable w.r.t. payment of remuneration to Non-Executive /Independent Directors before Companies Amendment Act 2020 –

Total remuneration payable to Non-Executive Directors could not exceed 1% of profits if the Company has Managerial Personnel (Managing Director / Whole Time Director / Manager) and 3% if the Company does not have Managerial Personnel. Off course, sitting fees could be paid to them to the tune of Rs.100,000 per meeting for Board or Committee thereof (irrespective of number of meetings in a year).

Further, as per Section 149(9), Independent Directors were not entitled for stock option and any compensation other than sitting fees and profit-based commission. This restriction is not applicable to Non-Independent Non-Executive Directors.

Situation in case of in adequacy of profits

Before the Companies Amendment Act 2020, if any company had inadequate or no profits, payment of remuneration to managerial personnel was possible in pursuance of Section 197(3) and Schedule V of the Act. However, whether this flexibility was available to Non-Executive Directors or not was matter of interpretation.

Section 197 (1) which is primary Section talking about ceiling on remuneration payable to Managerial Personnel refers to all type of positions which is as follows:

“Sec 197(1) – The total managerial remuneration payable by a public company, to its directors, including managing director and whole-time director, and its manager in respect of any financial year shall not exceed eleven percent. of the net profits of that company for that financial year computed in the manner laid down in Section 198 except that the remuneration of the directors shall not be deducted from the gross profits:

Provided that the company in general meeting may, authorise the payment of remuneration exceeding eleven percent. of the net profits of the company, subject to the provisions of Schedule V:

Provided further that, except with the approval of the company in general meeting by a special resolution—

(i) the remuneration payable to any one managing director; or whole-time director or manager shall not exceed five percent. of the net profits of the company and if there is more than one such director remuneration shall not exceed ten percent. of the net profits to all such directors and manager taken together;

(ii) the remuneration payable to directors who are neither managing directors nor whole-time directors shall not exceed,—

(A) one percent. of the net profits of the company, if there is a managing or whole-time director or manager;

(B) three percent. of the net profits in any other case.

Provided also that, where the company has defaulted in payment of dues to any Bank or public financial institution or non-convertible debenture holders or any other secured creditor, the prior approval of the Bank or public financial institution concerned or the non-convertible debenture holders or other secured creditors, as the case may be, shall be obtained by the company before obtaining the approval in the general meeting.”

However, Part I of Schedule V says as follows –

“No person shall be eligible for appointment as a managing or whole-time director or a manager (hereinafter referred to as managerial person) of a company unless he satisfies the following conditions….”

Inadequacy or no profit situation is dealt in Section 197(3), extract of the same (before the 2020 amendment) was as follows –

“Sec 197(3) – Notwithstanding anything contained in sub-Sections (1) and (2), but subject to the provisions of Schedule V, if, in any financial year, a company has no profits or its profits are inadequate, the company shall not pay to its directors, including any managing or whole-time director or manager, by way of remuneration any sum exclusive of any fees payable to directors under sub-Section (5) hereunder except in accordance with the provisions of Schedule V.”

And therefore, it appears that Managerial Personnel referred under Schedule V does not cover Non-Executive Directors. Accordingly, a strict interpretation was that in case of inadequacy or no profits, no compensation can be paid to Non-executive or Independent directors [apart from sitting fees provided under Section 197(5) and professional fees covered under Section 197(4) of the Act]. 

This situation required immediate revision because of some changes in SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 [SEBI LODR Regulations].

Change in SEBI LODR Regulations

On 9 May 2018, SEBI proposed amendment in SEBI LODR Regulations by way of insertion of Regulation 17(1B) whereby top 500 listed companies were asked to ensure that the Chairperson of the Board shall be a Non-Executive Director and not be related to the Managing Director or the Chief Executive Officer as per the definition of the term ‘relative’ defined under Companies Act, 2013.

As a result, all listed companies were required to separate position of Chairman and Managing Directorship. Logically many existing captains in Indian Corporate World were required to relinquish either position before 1 April 2020. [This date got extended to 1 April 2022]. It was necessary to look at the position of Non-Executive Directors liberally so that they are compensated adequately.

Further vide series of changes with respect to Independent Directors like data Bank, clearance of exam, the requirement of woman Independent Director, Nomination & Remuneration Committee requirement of 2/3rd Independent Directors etc., the position of Independent Director was becoming powerful as well as vulnerable in the Corporate World. And therefore, in order to attract right talent in the Independent Director position, it needed adequate compensation for them.

In this context Companies Amendment Act 2020 was passed by Lok Sabha on 19 September 2020, Rajya Sabha on 22 September 2020 and it got President’s assent on 28 September 2020.

Changes approved in Companies Amendment Act 2020

Under the Companies Amendment Act 2020, Section 197(3) and Section 149(9) were amended as mentioned below. Accordingly, while amending these Sections, Central Govt. amended Schedule V as mentioned below. It can be noted that the power to amend Schedules is with the Central Govt. as per the provisions of Section 467, and hence it may be amended anytime in the future too without requiring to seek approval of the Parliament.

Sections	Amendment
Section 197(3)	In Section 197(3) which speaks about payment of remuneration to directors in case of inadequacy or no profits, after the reference of managing director, whole time director and manager, the words ‘or any other non-executive director including independent director was added’
Section 149(9)	Earlier Section 149(9) said that independent directors shall not be entitled to stock options and may receive remuneration by way of sitting fees, reimbursement of expenses for participation in Board meetings and profit related commission as may be approved by the members. A proviso was inserted to the effect that if the company has no profits or inadequate profits, an independent director may receive remuneration, exclusive of sitting fees, in accordance with provisions of Schedule V.
Schedule V	After the words ‘managerial person’, the words ‘or other director’ were added The table providing for remuneration as per effective capital slabs was amended to provide separate limits for remuneration to managerial persons and for other directors

These changes happened with an idea that even in case of inadequacy of profits Companies should be free to compensate their Non-Executive Directors including Independent Directors.

Some common questions about this change

• If total remuneration to all directors is within 11% limits, but remuneration to Non-Executive Directors is exceeding 1% or 3% limits, whether still special resolution is mandatory?

[ANS: The limits of 1% or 3% are mentioned in second proviso to Section 197(1) and it provides that ‘except with the approval of members by special resolution… shall not exceed’. However, Section 197(3) says ‘notwithstanding anything contained in sub-Sections (1) and (2), but subject to provisions of Schedule V…. (Section 197(3) does not say anything about special resolution). Hence, there is ambiguity on the requirement to pass a special resolution in such cases. Therefore, it is recommended to carefully evaluate it on a case-to-case basis as Schedule V also prescribes the requirement to pass special resolution in certain cases.]   

• Under Companies Act, 2013 or under SEBI LODR Regulations, the requirement of maximum 5 years tenure is only for Managerial Persons and Independent Directors and there is no such requirement for Non-Executive Non-Independent Directors? In such case, whether approval of shareholders will be needed each year for remuneration to non-executive non-independent directors if company has inadequate or no profits?

[ANS: As per Schedule V – Part II – Section II – second proviso – clause (iii), approval of members may be taken for a maximum of 3 years at a time]

• In case of inadequate profits or no profits, remuneration can be paid as per effective capital slabs. As per Explanation II to Section IV of Part II of Schedule V, the effective capital shall be calculated as on the last date of the financial year preceding the financial year in which the appointment of the managerial person is made. Therefore in case of Non-Executive Non-Independent Directors, what should be considered as date of appointment (specially in cases where they are on Board since last 10-15 years or so)?

[ANS: In such cases, the date on which such director had got re-appointed pursuant to retirement by rotation may be considered]

• Whether Part I of Schedule V is also to be evaluated while appointing any Non-Executive Directors (including Independent Directors)?

[ANS: This amendment was done only in Part II of Schedule V. Hence Part I still continues to speak only about Managerial Personnel which are defined in Part I itself as Managing Director, Whole Time Director and Manager. Therefore, it can be said that Part I of Schedule V is not applicable appointing any Non-Executive Directors (including Independent Directors).     

Position of Private Company w.r.t. Managerial Remuneration

In the case of private companies, it can be said that Section 197 is not applicable as Section 197(1) starts with ‘The total managerial remuneration payable by a public company…..’. Section 196(4) says that appointment and remuneration of managing director, whole-time director and manager can be done in accordance with Section 197 and Schedule V. It does not speak about Non-Executive Directors. Further as per MCA notification dated 5 June 2015, the provisions of Section 196(4) and (5) shall not apply for private companies.

Hence, it can be said that there is no Section applicable to private companies which is linked to Schedule V and hence, Schedule V is not applicable to private companies. This results in a scenario where remuneration payable to any of the directors will not mandatorily require approval of members. Therefore in cases of  companies having any additional requirements in their Articles of Association or having Shareholders Agreement, it will be very important to take care of the mandatory requirements mentioned therein.

It may also be noted that the above-mentioned notification exempting private companies from the applicability of Section 196(4) and (5) was amended on 13 June 2017 to the effect that in order to avail these exemptions, the company should not have defaulted in the filing of financial statements or annual returns. Otherwise, the private company will lose the exemption and Section 196(4) will be applicable which will require compliance of Section 197 as well as Schedule V for appointment as well as remuneration to Managing Director, Whole Time Director, or Manager in private companies.

Lastly, it is important to note the proviso in the definition of ‘public company’ in Section 2(71) which is a deeming provision for company which may be a private company by its Articles of Association but a subsidiary of public company, and it shall be deemed to be a public company. In such cases, the provisions of Section 197, 149 and Schedule V shall be applicable for remuneration payable to managerial personnel as well as to Non-Executive Directors (unless it is situated in International Financial Services Centres (IFSC) for whom Section 197 is completely exempted as per a separate notification dated 4 January 2017).

Position of Private Company whose Debentures are listed

In the case of private companies whose debentures are listed, earlier as per the definition of ‘listed company’ under Section 2(52), such companies were considered as listed companies. Pursuant to Companies Amendment Act, 2020, a proviso was inserted for exempting certain classes of companies and certain classes of securities from the coverage of listed companies. Accordingly, Rule 2A was inserted in the Companies (Specification of Definitions Details) Rules, 2014 under which private companies which have listed their Non-Convertible Debentures issued on private placement basis shall not be considered as listed companies with effect from 1 April 2021.

In case of SEBI LODR Regulations, the provisions relating to appointment and remuneration of directors is mentioned only in Chapter IV which is applicable only to such companies who have listed their equity shares. For the companies which have listed only their debentures, the Chapter V of SEBI LODR Regulations is applicable, and it does not speak anything about appointment and remuneration of directors. The SEBI (Issue and Listing of Debt Securities) Regulations, 2008 which is applicable for debt listed companies also does not speak anything about appointment and remuneration of directors.

As mentioned above, the provisions of Section 196(4) and (5), 197, 149, Schedule V shall not be applicable for private companies which are not subsidiaries of public company and which have not defaulted in filing of financial statement and annual return. Looking at the other provisions applicable to such companies, it can be said that this position will remain the same even if such private company has listed its debentures.

Position of Section 8 Company

In the case of Section 8 companies, it must be noted it can be public companies or private companies. So if a Section 8 company is a private company, then it can be said to be covered under the above mentioned MCA notifications dated 5 June 2015 and 13 June 2017 exempting private companies from the applicability of Section 196(4) and (5) subject to conditions as mentioned above. However, if a Section 8 company is a public company, although there is a separate MCA notification providing exemptions to Section 8 companies, Section 196(4) and (5) are not covered therein. Hence the provisions of Section 196(4), (5), Section 197 as well as schedule V shall be applicable and will have to have complied for payment of remuneration to its directors.

It must also be noted that whether a Section 8 company can pay remuneration to its directors or not can be determined based on the conditions mentioned in the license issued by the MCA to Section 8 company at the time of its registration as a Section 8 company.

Role of Audit Committee and Nomination and Remuneration Committee

Sections 177 and 178 prescribe the mandatory requirement of constituting the Audit Committee and the Nomination and Remuneration Committee respectively in case of every listed public company such other public companies which have either of the following:-

• Paid up capital of Rs. 10 crores or more
• Turnover of Rs. 100 crores or more
• Outstanding loans, debentures and deposits, in aggregate, exceeding
  Rs. 50 crores

As per Rule 6 of the Companies (Meetings of Board and its Powers) Rules, 2014 read with Rule 4 of the Companies (Appointment and Qualification of Directors) Rules, 2014, the requirement to constitute these committees is exempt for such unlisted public companies which are a joint venture or a wholly-owned subsidiary or a dormant company categorized as such under Section 455.

For the companies where these committees are constituted, as per Section 177, 178 and SEBI LODR Regulations, the below requirements need to be complied with:

• Audit Committee – As per Section 177(4)(iv), approval of audit committee is required for any transaction with any ‘related party’ (including any modification to existing transactions with related parties). As per the definition of ‘related party’ under Section 2(76), all directors are considered to be related parties. Hence, while fixing or revising the remuneration payable to any director (be it a Managing Director or Whole-Time Director or Non-Executive Director), the approval of the Audit Committee will have to be taken. It must be noted that for equity listed companies for which corporate governance provisions under SEBI LODR Regulations are applicable, it is mandatory to seek prior approval of Audit Committee for any transaction with related party as per Regulation 24 of SEBI LODR Regulations. 

• Nomination and Remuneration Committee – As per Section 178(3) as well as Regulation 19(4) read with Part D of Schedule II of SEBI LODR Regulations, this Committee is required to formulate and recommend to the Board of Directors, a policy relating to remuneration for the directors, Key Managerial Personnel and other employees. Hence, in case of companies to whom SEBI LODR Regulations OR Section 178 are applicable and they have inadequate or no profits, before seeking approval of members for payment of remuneration over and above the limits provided in Section 197, it must be ensured that such remuneration is in accordance with the policy approved by the Board as recommended by this committee.

It must also be noted that under if the company has inadequate or no profits and is paying remuneration as per Section II of Part II of Schedule V, then it is mandatory to seek the approval of the Nomination and Remuneration Committee, if Section 178 is applicable to the Company.  Further as per Explanation IV to Section IV of Part II of Schedule V, the Nomination and Remuneration Committee, while approving this remuneration under Section II of Part II of Schedule V should take into account, the financial position of the company, trend in the industry, appointee’s qualification, experience, past performance, past remuneration, etc.; and should be in a position to bring about objectivity in determining the remuneration package while striking a balance between the interest of the company and the shareholders.

Disclosure of Interest

The provisions relating to requirement of disclosure of interest by directors are covered in Section 184. It speaks about disclosure of all such entities where a director may have any direct or indirect interest. Section 184(2) as well as Clause 3.2 of Secretarial Standards-1 (with regard to Board meetings) imposes a prohibition from participation of directors in Board meetings where the Board may be approving any transaction with a body corporate in which one or more directors hold more than 2% shareholding of that body corporate, or is a promoter, manager, CEO of that body corporate OR with a firm or other entity in which, such director is a partner, owner or member, as the case may be.

It must be noted that remuneration to be received from a company is a personal interest of a director in that particular company and it is a transaction between the company and that director. Literally speaking Section 184(2) does not prohibit the participation of directors at Board meetings where a transaction is being approved between the Company and that director. However, there is Section 184(5)(a) which says ‘Nothing in this Section shall be taken to prejudice the operation of any rule of law restricting a director of a company from having any concern or interest in any contract or arrangement with the company.’ There is Section 166 which lays down duties of directors and one of those duties is in Section 166(4) which says a director shall not involve in a situation in which he may have a direct or indirect interest that conflicts, or possibly may conflict, with the interest of the company. At the Board meeting where Board is approving the remuneration to be paid to that director, there seems to be a clear conflict of the director’s personal interest. Hence, on a joint reading of Section 184(5)(a) along with Section 166(4), it is recommended that irrespective of whether such director is an Executive or Non-Executive Director, he should disclose his interest at the decision-making forum and abstain from voting at such Board meeting.

Further Changes Proposed by SEBI w.r.t compensation to Independent Directors

Recently SEBI has at its Board meeting dated 29 June 2021 approved certain key amendments relating to regulatory provisions with respect to independent directors. One of those decisions is that SEBI shall be making a reference to the MCA, for giving greater flexibility to companies while deciding the remuneration for all directors (including independent directors), which may include profit linked commissions, sitting fees, ESOPs, etc., within the overall prescribed limit specified under Companies Act, 2013.

With this news coming into the public domain, now the industry is divided into two views that whether independent directors be allowed to participate in stock options or not!!!

Can Interested Director vote at the shareholder meeting?

In cases where remuneration of directors over and above the limits provided in Section 197 is put forth for approval of shareholders, a question arises that whether such interested directors who are shareholders too and their immediate relatives be allowed to vote or not?

As such Section 197 or schedule, V does not restrict the participation of interested shareholders from voting on the relevant matters. However, there is Section 188 which lists out certain transactions with related parties covered under Section 2(76) which cannot be done without the prior approval of the Board, and if those limits are in excess of certain prescribed limits, then approval of shareholders also needs to be taken. As per second proviso to Section 188(1), ‘no member of the company shall vote on such resolution, to approve the contract or arrangement which may be entered into by the company, if such member is a related party’  

One of such transactions is clause (d) – availing or rendering of services and there is another clause (f) – related party’s appointment to any office or place of profit in the company, its subsidiary company or associate company. There is a lot of deliberations in the industry that whether the appointment of director and payment of remuneration shall be covered under clause (d) as availing of services of a director or not? One may argue that for the remuneration as a director, clause (d) shall be applicable and for anything over and above remuneration, clause (f) shall be applicable. Another view can be that since for anything over and above remuneration clause (f) is applicable, the remuneration payable to directors should not be considered as a service under clause (d).

In any case, as per the fourth proviso to Section 188(1), nothing in Section 188(1) shall be applicable to any transaction entered into by the company in its ordinary course of business other than transactions that are not on an arm’s length basis. One can take a view that payment of remuneration to directors is in ordinary course of business and if the company is able to establish with justification in its Board and Committee minutes that although the remuneration proposed to be paid to director(s) is in excess of the limits provided under Section 197, but it is at arm’s length basis, then the company may avail the above-mentioned exemption from the applicability of Section 188.  In such case, the interested shareholders as well as their immediate relatives, being shareholders, can vote at the general meeting where approval of shareholders would be sought for payment of remuneration to directors over and above the limits given under Section 197.

Conclusion

It can be seen from the above discussion that since 2018, the provisions with regard to payment of remuneration to directors are continuously being relaxed and the approach of regulator is shifting from regulatory approval-based regime to governance based regime and the focus is on Ease of Doing Business and attracting good talent by deserving companies. However, more and more disclosures and checks and balances have been inserted. For e.g.: the role of the Nomination and Remuneration Committee, Audit Committee as discussed above, the requirement to disclose interest of director and abstain from voting at Board and Committee meetings and certification on e-forms by company’s key personnel and by third-party practicing professionals with a declaration that all relevant provisions of the Act have duly complied. Hence, although Regulator is relaxing the regulatory approval-based regime but at the same time, it is making provisions to ensure that only deserving companies can avail the benefit of these relaxations….

The above article is published in the August issue of the Chamber of Tax consultants journal.