By Mahak Tanwar
SEBI’s Eye-Opener for Independent Directors: Key Takeaways
SEBI’s Increased Scrutiny on Independent Directors Highlights the Need for Vigilant Corporate Governance
Introduction:
The Securities and Exchange Board of India (SEBI) has recently underscored the critical role of independent directors in maintaining corporate governance, particularly through its final order in the case of LEEL Electricals Ltd. This decision raises significant concerns regarding the responsibilities and potential liabilities of independent directors when financial misconduct is discovered within a company. SEBI imposed a fine of INR 10 Lakh on two independent directors of LEEL for failing to perform their statutory duties as members of the Audit Committee (AC) and for neglecting to protect shareholders’ interests.
These independent directors were initially assured by the company’s former promoter that their role on the board would not require specialized knowledge of law or finance and that their participation in AC meetings would be routine, with significant decisions being made during board meetings. Despite these assurances, SEBI held them accountable for neglecting their statutory obligations, which is particularly striking given their backgrounds—a retired Air Force Marshall and a physical therapist—neither of whom had expertise in reading financial statements or a comprehensive understanding of their responsibilities as independent directors.
This ruling is especially timely as many independent directors will be completing their tenures this year, necessitating the appointment of new directors. It is crucial to clarify the duties of independent directors and the qualifications required for these positions. This article examines the legal framework governing the responsibilities of independent directors in light of SEBI’s recent stringent actions and offers guidance for individuals considering or being approached for such roles.
Legal Considerations:
Independent directors are governed by several laws, regulations, and rules, including but not limited to the Companies Act, 2013, and the Companies (Appointment and Qualification of Directors) Rules, 2014. For listed companies, independent directors are also subject to the Securities and Exchange Board of India Act, 1992, the Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements) Regulations, 2015 (LODR Regulations), and the Securities and Exchange Board of India (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003 (PFUTP Regulations), among other applicable laws.
An independent director is defined as a director who is not a managing director, whole-time director, or nominee director. To qualify as an independent director, an individual must possess the necessary skills, experience, and knowledge in one or more fields relevant to the company’s business, such as finance, law, management, sales, marketing, administration, research, corporate governance, or technical operations.
Independent directors are appointed in a general meeting and can hold office for a maximum of five years, subject to re-appointment by a special resolution. Every listed company is required to have at least one-third of its board comprised of independent directors. Additionally, public companies with a paid-up share capital exceeding ten crores, a turnover exceeding one hundred crores, or outstanding loans, debentures, or deposits exceeding fifty crores must have at least two independent directors. Independent directors and their relatives must not have any pecuniary relationships with the company, except as provided under the Companies Act.
Furthermore, listed companies and public companies with a paid-up capital exceeding ten crores, a turnover exceeding one hundred crores, or outstanding loans, debentures, or deposits exceeding fifty crores must constitute an Audit Committee (AC) composed primarily of independent directors. The AC must be chaired by an independent director and include a minimum of three members.
As members of the AC, independent directors have a significant role in overseeing the financial affairs of the company. Their responsibilities include recommending the appointment of auditors, ensuring the independence and effectiveness of the audit process, examining financial statements and auditors’ reports, approving transactions with related parties, scrutinizing inter-corporate loans and investments, evaluating internal financial control and risk management systems, and monitoring the use of funds raised through public offers. The roles and responsibilities of AC members are further detailed in Part C of Schedule II of the LODR Regulations.
To qualify as an AC member, the Companies Act requires that individuals must be capable of reading and understanding financial statements. However, the LODR Regulations further mandate that all AC members must be financially literate, meaning they must have the ability to read and understand the balance sheet, profit and loss account, and statement of cash flows. At least one member of the AC must have experience in accounting or financial management, which can be demonstrated through professional certification in accounting or comparable experience.
The Critical Role of Independent Directors:
Independent directors are entrusted with upholding corporate governance standards, particularly through their involvement in key committees such as the AC. Their financial expertise is crucial as they oversee the appointment of auditors and scrutinize financial reports for potential irregularities.
SEBI has taken a stringent stance on holding independent directors accountable for fulfilling their roles, particularly when they serve as members of the AC. This section discusses the liability of independent directors who are part of the AC, followed by an examination of those who are not.
I. Independent Directors Serving on the Audit Committee:
In the case of Southern Ispat and Energy Ltd. (SIEL), the company fraudulently issued Global Depository Receipts (GDRs), with the funds being deposited in an overseas bank against which SIEL created a pledge in favor of loans issued by a company owned by one of its directors, Vintage. SEBI found the independent director liable under the PFUTP Regulations for failing to monitor the use of the funds raised through the GDRs and ensuring their transfer to the company’s accounts in India. The director, who was a member of the AC during the fraudulent transactions, was fined INR 10 Lakh.
Similarly, in the Fortis Healthcare Limited (FHL) case, SEBI held independent directors liable for their failure to discharge their duties adequately as AC members. The company was involved in routing funds for the benefit of its promoter entities, resulting in the artificial inflation of bank balances and misrepresentation of financial information. Despite one director’s defense of having minimal financial knowledge, SEBI imposed a penalty of INR 25 Lakh on each independent director, emphasizing that ignorance of financial matters is not a valid defense.
In contrast, in the case of Manpasand Beverages Ltd., where key management personnel were responsible for misrepresenting financial statements, the independent directors were held liable only for failing to diligently perform their statutory duties as AC members but were not found to have actively participated in the manipulation.
II. Independent Directors Not Serving on the Audit Committee:
SEBI has adopted a more lenient approach towards independent directors not serving on the AC, provided they can demonstrate that they were not involved in any financial wrongdoing. For example, in a case involving fraudulent issuance of preferential shares, an independent director was not held liable as they were not present at the board meetings where the issues were approved.
However, in the case of MPS Infotecnics Ltd., a non-executive independent director was held liable under the PFUTP Regulations despite having no knowledge of the fraudulent scheme. SEBI imposed a fine of INR 25 Lakh, stating that independent directors have a greater responsibility to protect the interests of minority shareholders and cannot claim ignorance of the company’s business conduct.
Suggested Measures for Independent Directors:
Based on SEBI’s recent rulings, independent directors should consider the following precautions:
- Financial Proficiency: Independent directors, especially those serving on the AC, should possess strong financial literacy and the ability to understand complex financial statements. Ignorance or lack of expertise in financial matters is not a valid defense against liability.
- Active Participation: Independent directors must actively participate in board meetings, especially in approving the company’s financial statements. They should ensure that internal and statutory audits are conducted independently and efficiently.
- Timely Action: If financial irregularities are discovered, independent directors should take prompt action. If satisfactory explanations are not provided by management, resignation should be considered.
- Vigilance: Independent directors, even those not serving on the AC, must remain vigilant about their roles within the company. They should be aware of the transactions they are involved in and maintain a general understanding of the company’s affairs.
Conclusion:
SEBI’s recent actions underscore the importance of independent directors fully understanding their roles and responsibilities. Assurances from promoters or key management personnel that the role of an independent director is minimal are no longer acceptable. Penalties imposed by SEBI, ranging from INR 2 Lakh to INR 25 Lakh, serve as a deterrent and highlight the risks associated with failures in corporate governance.
Independent directors must act diligently and proactively to protect themselves from liability. SEBI’s increased focus on the role of independent directors marks a significant step towards improving corporate governance in India.