EVOLUTION OF INDEPENDENT DIRECTORS

Corporate governance models in India are borrowed from those in the United States of America
and the United Kingdom from the recommendations of Cadbury Committee 1992 of the UK and
the Sarbanes-Oxley Act of 2002 of the US. Governance in the US aims at disciplining the
management, while this aims at disciplining the dominant shareholder and protecting interests of
minority shareholders in India. Independent directors, who are truly independent, can be an
effective barricade against corporate frauds. Active oversight and prudent judgment may suffer
when large numbers of directors are closely associated with the executive leadership.

IN THE US

The practice of having independent directors in corporate boards was originated in the US. It was
felt that the role of the independent directors was to protect the shareholders from the excesses of
the management. In 1976, the Corporate Director’s Guidebook published by the American Bar
Association (ABA) laid down a stricter criterion when deciding between management and non-
management directors, implying that even a person who was formerly employed by the firm
would be deemed to be a management director. The following year, a revised edition of the
Corporate Director’s Guidebook was published which clarified that the decision on whether a
person is a non-affiliated, non-management director was based on the subjective judgment of the
board which should be based on the absence of any relationship that could interfere with the
director’s independent judgment.

In 1983, the New York Stock Exchange (NYSE) Audit Committee Listing Standards Committee
clarified that an individual with “customary commercial, industrial, banking, or underwriting
relationships with the company” was eligible to serve on audit committees unless the board
formed the opinion that such relationships “would interfere with the exercise of independent
judgment as a committee member”. In 1999, the Blue Ribbon Committee on Audit Committee
Effectiveness (BRC) set out much stricter criteria for determining independence and
recommended the barring of individuals who were linked to a firm which has had significant
business relations with the company during the preceding five years.

The final NYSE Corporate Governance Rules approved by the Security and Exchange
Commission (SEC) on November 4, 2003, added more specifications to the BRC
recommendations. It lay down that no director should be considered as ‘independent’ unless the
board had affirmatively determined that the director had no material relationship with the
company either directly or through an organisation that had a relationship with the company.

IN THE UK

The UK regulators and policymakers rely on companies to voluntarily follow the principles. The
tone was set by the Cadbury Committee Report of 1992, which called for listed company boards
to have a judicious mix of executive and non-executive elements. The class of non-executive
directors whose prime contribution to the board was expected to be ‘independence of judgment’
was required to include within their ranks, a majority of independent directors. The Cadbury
Committee also recommended that the audit committee should be comprised entirely of non-
executive directors with a majority of independent directors. This Report was followed in 1996
by the Greenbury Committee Report on Directors’ Remuneration, which recommended that all
listed companies should have a remuneration committee, composed exclusively of non-executive
directors. The term ‘non-executive director’ appeared to have been used as an interchangeable
expression for ‘independent director’.

The Hempel Committee Report, the recommendations of the Cadbury Committee Report and the
Greenbury Committee Report were consolidated into a single Combined Code on Corporate
Governance (‘Combined Code’) published by the Financial Reporting Council in 2003. The
Combined Code recommended that all FTSE 350 boards should have a majority of independent
non-executive directors. The Combined Code also for the first time laid down a detailed set of
criteria that the board is expected to take into account when deciding on a particular director’s
independence:

(i) Being an employee of the company or group within the past five years
(ii) Has, or has had a material business relationship with the company either directly, or
as a partner, shareholder, director or senior employee of a body that has such a
relationship with the company within the past three years
(iii) Has received or receives additional remuneration from the company apart from a
director’s fee; participates in the company’s share option or a performance-related
pay scheme; or is a member of the company’s pension scheme
 (iv) Has close family ties with any of the company’s advisers, directors or senior
employees
(v) Holds cross-directorships or has significant links with other directors through
involvement in other companies or bodies
(vi) Represents a significant shareholder
(vii) Has served on the board for more than nine years from the date of his first election.

THEORETICAL FOUNDATIONS FOR THE ORIGIN OF INDEPENDENT

DIRECTORS

The concept of the independent director originated in both legal and economic theories. The
theories explain why the concept was considered as a mechanism to deal with the manager-
shareholder agency problem. This was essentially due to the fact that the manager-shareholder
agency problem was predominant in the U.S. and the U.K.

1. THE BERLE AND MEANS STUDY

Berle and Means concludes that there is a ''separation of ownership and control" in which the
individual interest of shareholders is made subservient to that of managers who are in control
of a company."' Due to the diffusion in ownership, the shareholders are unable to maintain
vigil over the managers," as widely dispersed shareholders lack sufficient financial incentives
to intervene directly in the affairs of the company. Managers, being unchecked, may abuse
their position by acting in their own interests rather than the interests of the shareholders
which they have a duty to promote. The Berle and Means study proved influential. Much of
the effort in corporate law and governance reform over the years has sought to address the
agency problem identified by Berle and Means.

2. ECONOMIC ANALYSIS OF THE AGENCY PROBLEM

As the separation of ownership and control leads to the manager - shareholder agency
problem, it became the subject of study by economists.
 Applying principles of agency to the modem corporation," Jensen and Meckling argued that
whenever a principal engages an agent to do something which involves some decision-
making authority given to the agent, the latter may not always act in the interests of the
principal." This imposes significant agency costs as the principal is required to establish
appropriate incentives for the agent and monitor the agent's action.
Viewing the agency theory in the context of the Berle & Means Corporation, it becomes clear
that shareholders (who are the principals) suffer from agency costs on account of the actions
of managers (the agents and persons in control of the corporation). The end result of this
approach is the need for proper monitoring of the managers so as to protect the interest of the
shareholders.

Role and Functions of Independent Directors:

1) To bring an independent judgment on issues of strategy, performance, risk management, resources,

key appointments and standards of conduct;

2) To bring objectivity in the evaluation of the performance of Board and management;

3) To scrutinize the performance of management in meeting agreed goals and objectives;

4) To satisfy themselves on the integrity of financial information and that financial controls and the
systems of risk management are robust and defensible;

5) To safeguard the interests of all stakeholders, especially minority shareholders;

6) To balance the conflicting interests of all stakeholders;

7) To determine appropriate levels of remuneration of executive directors, key managerial personnel

and senior management and have a prime role in appointing and where necessary recommending
removal of executive directors, KMP and senior management;

8) To moderate and arbitrate in the interest of the company as a whole.

WHO CAN BE AN INDEPENDENT DIRECTOR - Section 149(6) of the Companies Act, 2013