September 1, 2021

Discussion Paper on Review of Regulatory Provisions relating to Independent Directors - MMJC

Why this Discussion Paper: As per the Code of Conduct, Independent Directors (IDs) are expected to pay specific attention on the integrity of financial information and on related party transactions along-with safeguarding the interests of the minority shareholders.

Accordingly, the Audit Committee of the board which is responsible for approving related party transactions and for oversight of the financial reporting process and the sanctity of financial information, is mandated to have at least two–third of Independent Directors.

Besides, IDs are also expected to bring in independent judgement on the Board’s deliberations especially on issues of strategy, performance, risk management, resources, key appointments and standards of conduct; as well as bring an objective view in the evaluation of the performance of board and management.

Despite the above provisions and various measures taken, concerns around the efficacy of independent directors as a part of corporate governance framework continue. There is therefore a need to further strengthen the independence of IDs and enhance their effectiveness in protection of the interest of the minority shareholders, and other functions.

In this regard, sharper focus is required in the areas of appointment and role of the independent directors. Accordingly, proposals including broadening the eligibility criteria for IDs, the process of appointment / re-appointment and removal of IDs, enhancing transparency in the nomination and resignation of IDs, strengthening the composition of Board Committees, are being placed for public consultation. Additionally, views are also sought on the need for review of remuneration of IDs.

Sl.No	Existing Provision	Proposal	Rationale for this
1	Definition of Independent Director : Regulation 16(1) Persons who have been employees/ KMPs or his/her relatives have been KMPs of the listed entity / its holding company / subsidiary / associate company in the past 3 years, cannot be appointed as IDs. Cooling-off period of 3 years in case the person has been an employee / KMP or his / her relative has been a KMP of the listed entity / its holding company / subsidiary / associate company Cooling-off period of 2 years in case of a material pecuniary relationship between person or his / her relative and the listed entity / its holding company / subsidiary / associate company.	It is proposed that KMPs or employees of promoter group companies, cannot be appointed as IDs in the company, unless there has been a cooling-off period of 3 years. The said restriction shall also extend to relatives of such KMPs for the same period. No change is proposed Cooling-off period shall be harmonized to 3 years	In order to establish the independence of the person it is important that KMPs or employees of companies forming part of the promoter group and relatives of such KMPs should also be excluded from acting as independent directors. As cooling period is not uniform hence change is proposed.
2	Appointment and Re-appointment of Independent Directors: Appointment of IDs, the Nomination and Remuneration Committee (“NRC”) proposes a person as ID, who is then appointed by the Board. Subsequently, shareholders approve the appointment through an ordinary resolution (special resolution in case of re-appointment).	Appointment and re-appointment of IDs shall be subject to “dual approval”, taken through a single voting process and meeting following two thresholds: – i. Approval of shareholders ii. Approval by ‘majority of the minority’ (simple majority) shareholders. ‘Minority’ shareholders would mean shareholders, other than the promoter and promoter group. The approval at point (i) above, shall be through ordinary resolution in case of appointment and special resolution in case of re-appointment. 5. If either of the approval thresholds are not met, the person would have failed to get appointed / re-appointed as ID. Further, in such case, the listed entity may either: i. Propose a new candidate for appointment / re-appointment or ii. Propose the same person as an ID for a second vote of all shareholders (without a separate requirement of approval by ‘majority of the minority’), after a cooling-off period of 90 days but within a period of 120 days. Such approval for appointment/re-appointment shall be through special resolution and the notice to shareholders will include reasons for proposing the same person despite not getting approval of the shareholders in the first vote.	Present system of appointment of IDs may be influenced by the promoters – in recommending the name of ID and in the approval process by virtue of shareholding. This may hinder the “independence” of IDs and undermine their ability to differ from the promoter, especially in cases where the interests of promoter and of minority shareholders are not aligned. Additionally, considering that the primary duty of Independent Directors is to protect the interest of minority shareholders, there is a need for minority shareholders to have greater say in the appointment / re-appointment process of IDs. Israel: It has provisions for appointment of independent directors by minority shareholders. UK: In case of premium listed companies which have a controlling shareholder, a dual voting structure has been adopted whereby the appointment of independent directors must be approved both by the shareholders as a whole and by the independent shareholders. If either of the resolutions fails, but the company still wants to propose the person as an independent director, it is allowed to put the matter to a second vote of all shareholders (including the controlling shareholder(s)).
3	Removal of Independent Director At present, an ID can be removed through a simple majority in the first term and through a special resolution in case of second term, after giving him a reasonable opportunity to be heard. Since, the ID may be removed through a simple majority, the promoter may have significant influence in the removal process by virtue of shareholding.	Removal of IDs shall be subject to “dual approval”, taken through a single voting process and meeting following two thresholds: – i. Approval of shareholders. ii. Approval of ‘majority of the minority’ (simple majority) shareholders. ‘Minority’ shareholders would mean shareholders, other than the promoter and promoter group. The approval at point (i) above, shall be through ordinary resolution in case of removal in the first term and special resolution in case of removal in the second term. If either of the approval thresholds are not met, the person would have failed to get removed as an ID. In such case, the removal of such ID may again be proposed through a second vote of all shareholders (without a separate requirement of approval by ‘majority of the minority’), after a cooling-off period of 90 days but within a period of 120 days. Such approval for removal shall be through special resolution and the notice to shareholders will include reasons for proposing the removal again despite not getting approval of the shareholders in the first vote.	Consistent with the greater say of the minority shareholders proposed in the appointment of an ID, minority shareholders, should also be given a say in the removal process of IDs as well.
4	Enhancing and bringing in more transparency in the role of NRC At present, all members of the NRC should be non-executive, with a majority of independent directors. Further, LODR Regulations prescribe the following role of the nomination and remuneration committee (NRC) in the matter of appointment of IDs: a. Formulation of the criteria for determining qualifications, positive attributes and independence of a director b. Identifying persons who are qualified to become directors in accordance with the criteria laid down, and recommend to the board of directors for their appointment and removal c. Whether to extend or continue the term of appointment of the independent director, on the basis of the report of performance evaluation of independent directors.	The following procedure shall be followed by NRC for selection of candidates for the role of ID – a. Process for shortlisting of the candidate i. For each appointment, the NRC shall evaluate the balance of skills, knowledge and experience on the board. In the light of this evaluation, a description shall be prepared of the role and capabilities required for a particular appointment. ii. The person who is recommended to the Board for appointment as ID should have the capabilities identified in this description. iii. For the purpose of identifying suitable candidates, the committee may:  Use services of an external agencies  Consider candidates from a wide range of backgrounds, having due regard to diversity and  Consider the time commitments of the appointees b. Disclosures to be made to shareholders The notice for appointment of director shall include the following disclosures: i. Skills and capabilities required for the appointment of the ID and how the proposed individual meets the requirement of the role. ii. Channels used for searching appropriate candidates. In case, one of the channels is ‘recommendation from a person’, the category of such person (viz. promoters, institutional shareholders, directors (non-executive, executive, ID) etc) shall be disclosed. 4. Composition of NRC may be modified to include 2/3rd IDs instead of majority of IDs.	While the law requires NRC to lay down detailed criteria of qualifications and attributes for directors, apparently there is a lack of transparency in the process followed by NRC. There is therefore, a need to prescribe disclosures regarding the process followed by NRC for selection of candidates for the post of ID.
5	Prior approval of shareholders for appointment of IDs As per the current practice, companies appoint independent directors as additional directors, subject to approval of the shareholders at the next general meeting. It is therefore possible that a person gets appointed as an additional independent director, just after an AGM and then serves on the board of directors, without shareholder approval, till the next AGM. 2. In the case of vacancy of an Independent Director due to resignation or removal, existing provisions provide a time-period of up to 3 months to appoint another director. However, the approval of shareholders would be taken at the next AGM, which could potentially be up to another 9 months away.	Independent Directors shall be appointed on the board only with prior approval of the shareholders at a general meeting. 6. In case, a casual vacancy arises due to resignation / removal / death / failure to get re-appointed etc., the approval of shareholders should be taken within a time period of 3 months.	There can be a significant time gap between the appointment of an independent director and approval of shareholders, which is not in the best interest of especially the minority shareholders. There have been cases in the past where the shareholders have rejected the appointment of IDs while these IDs had served on the Board for few months. Reduction/ elimination of this gap may give more say to shareholders in the appointment process.
6	Resignation of Independent Director As per current provisions of LODR, the resigning ID within 7 days of his resignation, has to disclose to stock exchanges, detailed reasons for the resignation along-with a confirmation that there is no other material reason for resignation other than those already provided.	The entire resignation letter of an ID shall be disclosed along with a list of his/her present directorships and membership in board committees. If an ID resigns from the board of a company stating reasons such as pre-occupation, other commitments or personal reasons, there will be a mandatory cooling-off period of 1 year before the ID can join another board. It is proposed that there should be a cooling-off period of 1 year before a director can transition from an ID to a whole-time director	It is observed that IDs often resign for reasons such as pre-occupation, other commitments or personal reasons and then join the boards of other companies. There is, therefore, a need to further strengthen the disclosures around resignation of Independent Directors. Cases have also been observed where IDs have resigned and then joined the same company as an executive director. While there may be valid reasons for transition from an ID to executive director, such instances where an ID knows that he/she may move to a larger role in the company in the near future, may practically lead to a compromise in independence.
7	Composition of Audit Committee The LODR Regulations cast specific responsibilities on the Audit Committee (two-thirds of its members are independent directors), to review financial statements, scrutinize inter-corporate loans & investments and valuation of undertakings and assets of the listed entity, wherever applicable. In case of related party transactions, prior approval of the Audit Committee is mandatory. SEBI has mandated that a committee of Independent directors should give their recommendations on open offers and schemes of arrangements.	Audit committee shall comprise of 2/3rd IDs and 1/3rd Non-Executive Directors (NEDs) who are not related to the promoter, including nominee directors, if any.	Considering the importance of the Audit Committee with regard to related party transactions and financial matters,
8	Review of Remuneration As per the Companies Act, apart from reimbursement of expenses, IDs are permitted to be paid sitting fees (max 1 lakh) and profit linked commission within an overall limit. Further, in terms of both Companies Act and LODR Regulations, IDs cannot be given stock options.	No concrete proposal but comments are sought on following questions: Whether there is a need for reviewing the remuneration structure for IDs. If so, a. Whether ESOPs with a long vesting period of 5 years, be permitted for IDs, in place of profit linked commission and b. What should be the maximum limit of remuneration through ESOPs. Since any modification in the existing remuneration structure of IDs will require changes to the Companies Act, based on the comments received and further analysis of the same, appropriate recommendations will be sent to the Ministry of Corporate Affairs (MCA) for their consideration.	While there are concerns that a large remuneration may compromise the independence of ID, lesser compensation may also not attract competent IDs on the boards of the listed entities. 3. In this regard, one area of debate is removal of profit linked commission and increase in sitting fees paid to Independent Directors. This is with a view that the remuneration to IDs should be on the basis of their value and time-commitments to the company, without linking the same to the profits of the company. This would lead to IDs getting a fixed fee, without having any stake in the long-term growth of the company. 4. On the other hand, linking remuneration to profit or performance linked commission ensures that IDs have “skin-in-the-game”. The concern with this approach – that profit or performance linked commission may encourage short-termism and lead to conflicts, may be addressed by permitting ESOPs to IDs (instead of profit linked commission) with a long vesting period of say, 5 years. ESOPs are a commonly used method of remuneration for employees, especially in technology and start-up companies, since it ensures alignment of interests of the company and of the employees.

Copy of this Consultation Paper can be accessed at below mentioned link: https://www.sebi.gov.in/reports-and-statistics/reports/mar-2021/consultation-paper-on-review-of-regulatory-provisions-related-to-independent-directors_49336.html

Discussion Paper on Review of Regulatory Provisions relating to Independent Directors - MMJC

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