Introduction
If recent SEBI orders are considered, the title, ‘guardians of corporate governance’ seems increasingly misapplied for a cross section of independent directors. SEBI orders consistently point out short comings in the actions of independent directors specifically while discharging functions as members of audit committee (“ACom”).
Sebi’s Crackdown on Negligent Independent Directors
An example of this can be seen in SEBI’s order in the matter of LEEL Electricals Limited (“LEEL”)[1]. While the order seems to suggest that all was not well in the way LEEL was operating (the order is replete with reference to activities such as diversion of funds to related parties and misrepresentation of financial statements), SEBI’s order is scathing on the role that the independent directors played. To begin with – SEBI found that the ACom meetings were not held over decades, minutes of meetings were fabricated and made to be signed by the ACom. In clear contravention of the SEBI (Listing Obligations and Disclosure Requirements) Regulations[2] (“LODR Regulations”), ACom’s approval was never obtained for any of the related party transactions.[3] Lastly, the ACom failed to discharge their key obligations of reviewing and managing the financials of LEEL as mandated by The Companies Act, 2013 (“Companies Act”)[4] and the LODR Regulations. SEBI found the defense presented by independent directors glaringly inadequate. The two independent directors in the ACom admitted to have “no experience of finance and the corporate world.”[5] However, theysought relief by claiming that the promoter gave them the impression that “serving as an independent director would not require any specialized knowledge of law and finance, with limited advisory role.”[6] With regards to the ACom meetings, the independent directors were made to understand such meetings are “normal statutory requirements and a routine affair”.[7]
Not surprisingly, SEBI came to the conclusion that “alarming is the revelation that the purported safeguard against financial misconduct, the ACom, existed merely as a nominal entity on paper, devoid of substantive oversight or regulatory efficacy, which allowed fraudulent activities to continue unchecked.”[8] With regards to the defense of misleading directions by the promoter – SEBI held that being misled by the higher management cannot serve as a plausible excuse for failing to discharge the responsibilities entrusted to ACom. Being an ACom member requires active and diligent oversight and the independent directors must face the consequences of their inability to act decisively in the face of financial malfeasance.[9]
In the past as well, there have been instances where independent directors have taken a very cavalier approach in terms of their duties and responsibilities as serving members of Acom. The common line of defense in some of these matters consisted of independent directors admitting to having no financial knowledge or experience yet agreeing to serve as members of ACom.[10] Amazingly, in some instances independent directors also took the plea that they accepted the appointment because they were ‘made to understand’ that specialized knowledge was not required.[11] Interestingly enough, an argument was also proffered by the independent directors that they were the ones wronged as the management neglected to inform them of their duties and obligations as mandated under the LODR Regulations.[12] SEBI has correctly disagreed with this line of argument and surmised that lack of financial knowledge cannot be an effective alibi.
Balancing Accountability with Safeguards
Some instances seem to suggest that management is using independent directors as a tool to push agendas in complete disregard of the principles of governance. Reading of recent developments indicates that the scrutiny by regulator is expected to intensify, especially in the case of ‘crony’ independent directors. Rightfully, the regulator has taken a strict view of the role played by independent directors and time is running out for errant independent directors.[13]
The Companies Act provides that “the appointment process of independent directors shall be independent of the company management; while selecting independent directors the Board shall ensure that there is appropriate balance of skills, experience and knowledge in the Board so as to enable the Board to discharge its functions and duties effectively.”[14] There is no ambiguity in the standard to be followed by the board. That being said, a fairly recent case involved appointment of ‘financially illiterate’ independent directors based solely on their qualifications as friends of the promoters.[15] Thankfully, the regulatory scrutiny narrowed the field for ‘friends and buddies’ when it comes to independent directors and held the company liable for failure to appoint ‘unrelated persons’.[16]
However, further action is needed. It is the duty of both independent directors and promoters to ensure they are truly ‘unrelated’ as mandated under Companies Act[17]. Moreover, independent directors must honestly evaluate their levels of financial proficiency before they accept a position on the ACom. Keeping aside the statutory qualifications for a minute, it is obvious that being an ACom member demands rather nuanced financial acumen. Independent directors cannot lose sight of the fact that they need to exercise constant vigilance and always act ‘independent’ in the truest sense.
Way Forward
Randall Morck in the introduction to his paper on Independent Directors and Behavioral Finance in Corporate Governance begins with a quote by Woodrow Wilson — “Loyalty means nothing unless it has at its heart the absolute principle of self-sacrifice.” He discusses how misplaced loyalty lies at the heart of numerous scandals in corporate governance where directors overlooked their duties towards the shareholders and obedience to the law in the midst of their loyalty towards over-zealous executive officers.[18] “Where ignorance is bliss, ‘tis folly to be wise.” This famous line by Thomas Gray has passed into folklore. While this may be true in some circumstances (who wants to know a large spider was lurking under their bed last night?), when it comes to corporate governance, Gray’s adage is not effective.[19] SEBI certainly seems to agree with this. Ergo, SEBI’s heightened scrutiny underscores a push for independent directors to do a better job as governance gatekeepers.
Written By Probal Bhaduri (Managing Partner) and Aastha Singh (Associate)
[1] SEBI Order No. WTM/AB/CFID/CFID/30277/2024-25 dated April 18, 2024
[2] SEBI (Listing Obligations and Disclosure Requirements) Regulations, Regulation 18(3) read with Schedule II, Part C
[3] SEBI (Listing Obligations and Disclosure Requirements) Regulations, Regulation 23 (2)
[4] The Companies Act, 2013, Section 177
[5] Supra note 1, pages 20 & 21
[6] Ibid
[7] Ibid
[8] Supra note 1, page 60 para 146
[9] Supra note 1, page 60 para 147
[10] SEBI Order No. EAD/BJD/NJMR/1-5/2018-19 dated April 23, 2018
[11] SEBI Order No. QJA/KS/CFID/CFID/29897/2023-24 dated December 22, 2023
[12] SEBI Order No. WTM/MPB/EFD-1-DRA-IV/67/2019 dated September 27, 2019; SEBI (Listing Obligations and Disclosure Requirements) Regulations, Regulation 4(2)(f)(iii)(14)
[13] SEBI Order No. Order/AA/RK/2022-23/20965-20973 dated October 31, 2022
[14] The Companies Act, 2013, Section 149(8) read with Schedule IV, Part IV
[15] SEBI Order No. WTM/ASB/CFID/26926/2023-24 dated May 31, 2023
[16] Ibid
[17] The Companies Act, 2013, Section 149(6)(b)(ii)
[18] Randall Morck, “Behavioral Finance in Corporate Governance – Independent Directors, Non-Executive Chairs, and the Importance of the Devil’s Advocate” accessed on June 14, 2024 at <link>
[19] Anneliese Reinhold, “Where ignorance isn’t bliss start-ups and corporate governance” accessed on June 18, 2024 at <link>
