Yes, Governance Matters.: SEBI’s eye opener for Independent Directors: What to look out for?

SEBI’S EYE OPENER FOR INDEPENDENT DIRECTORS: WHAT TO LOOK OUT FOR?

• SEBI demonstrates an increased spotlight on the role of independent directors, a step towards improved corporate governance
• SEBI imposes a fine on independent directors when financial misconduct is unearthed for neglecting their statutory duties
• Independent directors should understand their roles and responsibilities and act diligently to shield themselves from liability

INTRODUCTION:

SEBI’s final order in the matter of LEEL Electricals Ltd¹ (“LEEL”) amongst other things, raises pertinent questions regarding the responsibilities and liabilities of independent directors, when financial misconduct is unearthed within a company. In this case, a fine of INR 10 Lakh was imposed by SEBI on the two independent directors, for their failure to discharge their statutory duties as members of the Audit Committee (“AC”) of LEEL and protecting the interest of the shareholders of the company.²

The independent directors in question were approached by the erstwhile promoter to join LEEL’s board on the assurance that their role would ‘not require any specialized knowledge of law and finance’ and that AC meetings were ‘routine’ and ‘actual decisions would be taken by the board in board meetings’.³ Notwithstanding these assurances, SEBI held them accountable for neglecting their statutory duties.⁴ This is particularly striking in light of the fact that neither director (being a retired Air Force Marshall and a physical therapist by profession) had proficiency in reading financial statements nor a thorough understanding of their roles as independent directors.⁵

The timing of this order couldn’t be more crucial as many independent directors will have to vacate their office this year as the law permits only a limited tenure which will get completed for many in 2024, necessitating the filling of numerous vacant positions.⁶ It becomes important to delineate the duties of independent directors and the necessary qualifications attached thereto for individuals looking to/being sought to take up these positions. This article elucidates the legal framework governing the responsibilities of independent directors in light of SEBI’s recent, stringent stance, and provides guidance for individuals considering or being approached for such roles.

LEGAL CONSIDERATIONS:

Independent Directors are governed by a range of legislations, rules and regulations including but not limited to the Companies Act, 2013 (“Companies Act”) and the Companies (Appointment and Qualification of Directors) Rules, 2014 (“Appointment and Qualification Rules”). Additionally, for listed companies, they are bound by the provisions of the Securities and Exchange Board of India Act, 1992 (“SEBI Act”), the Securities And Exchange Board Of India (Listing Obligations And Disclosure Requirements) Regulations, 2015 (“LODR Regulations”), Securities and Exchange Board of India (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003 (“PFUTP Regulations”) and other applicable regulations governing the functions of directors in companies.

An independent director is a director who is not a managing director or whole-time director or nominee director.⁷ In order to be qualified as an independent director, an individual must possess appropriate skills, experience and knowledge in one or more fields of finance, law, management, sales, marketing, administration, research, corporate governance, technical operations or other disciplines related to the company’s business.⁸

An independent director must be appointed in a general meeting and can hold office for a maximum of 5 years, subject to re-appointment by a special resolution.⁹ Every listed company shall have at least one-third of its total directors as independent directors.¹⁰ Moreover, public companies having a paid-up share capital of over ten crores or a turnover of over hundred crores or outstanding loans, debentures or deposits of over fifty crores are required to have at least two independent directors.¹¹ Neither an independent director nor any of his/her relatives must be associated pecuniarily with the company except as provided for under the Companies Act.¹²

Further, every listed company and all public companies having a paid up capital of over ten crores or a turnover of over hundred crores or outstanding loans, debentures or deposits of over fifty crores¹³ are required to constitute an Audit Committee (“AC”) composed of a majority of independent directors.¹⁴ The AC must be chaired by an independent director and must have a minimum of three members.¹⁵

As members of the AC, independent directors play an elaborate role in examining and managing the financials of the company. Among other things, they are required to make recommendations for the appointment of company auditors, ensure their independence and effectiveness of the audit process, examine financial statements and auditor’s reports, approve transactions with related parties, scrutinize inter-corporate loans and investments, evaluate internal financial control and risk management systems, and monitor the end use of funds raised through public offers and related matters.¹⁶ The roles and responsibilities of AC members are further substantiated in Part C of Schedule II of the LODR Regulations.¹⁷ The role of audit committee also includes review the functioning of the whistle blower mechanism. Thus, Independent directors must ensure the existence of a functional vigil mechanism.

In order to qualify as a member of the AC, the Companies Act only requires that the persons in question must have the ability to read and understand financial statements.¹⁸ However, the LODR Regulations further mandate that all members of the audit committee must be financially literate i.e., ability to read and understand the balance sheet, profit and loss account and statement of cash flows; and at least one member of the AC shall have accounting or related financial management experience (which may be evinced by way of professional certification in accounting or any other comparable experience or background).¹⁹

Thus, independent directors are vested with a broad range of responsibilities and powers under the Companies Act, and play an even more elaborate and intricate financial role as members of the AC. 

CRITICAL ROLE OF INDEPENDENT DIRECTORS:

Independent directors are entrusted with the critical task of upholding corporate governance standards, particularly through their participation in key committees such as the AC. Their expertise in financial matters is paramount, as they oversee the appointment of auditors and scrutinize financial reports for irregularities.

SEBI has adopted a stringent stance on the accountability of independent directors for fulfilling their roles in recent times. They are now being held accountable for any lapses in their statutory duties, particularly in cases where they are expected to exercise diligence. This scrutiny becomes even more stringent when independent directors also serve as members of the AC. Consequently, this section is divided into two parts: the first part discusses the liability of independent directors who are part of the AC, while the second part delves into the liability of those who are not members of the AC.

I. Independent Directors who are part of the Audit Committee:

In the matter of disclosures by Southern Ispat and Energy Ltd. (“SIEL”),²⁰ the company had fraudulently issued Global Depository Receipts (“GDR”). Here, the funds received from the issue of the GDRs were deposited in an overseas bank, against which SIEL had created a pledge in favor of any loans issued by a company owned by one of the directors (“Vintage”). Vintage was among the subscribers to the GDRs and paid for them by obtaining a loan from the overseas bank. Upon defaulting, the bank adjusted the loan amount of Vintage against the pledged proceeds of SIEL.

Subsequently, the GDRs of Vintage were canceled and converted into equity shares and sold in the market. Ultimately, SIEL defrauded the Indian investors by concealing information of entering into pledge agreement which made investors believe that GDRs were genuinely subscribed to, while loan default alone caused loss to the shareholders of SIEL.

Here, the AO found the independent director liable under PFUTP Regulations as they had ‘the added responsibility to monitor the end use of the funds that were raised by issue of the GDRs and also ensuring their transfer to the accounts of the company in India.’²¹ The independent director was a part of the AC for the period that the above fraudulent transactions were carried out and had attended all AC meetings during that financial year. Accordingly, a fine of INR 10 lakh was imposed.

In a similar case, in the matter of Fortis Healthcare Limited (“FHL”),²² the company was involved in aiding and abetting the routing of funds from FHL for the benefit of its promoter entities. The structured movement of funds from FHL’s subsidiaries resulted in artificial inflation of the bank balance as well as misrepresentation and non-disclosure of material information in FHL’s consolidated financials. This case serves as an important point for understanding the role of members of the AC and circumstances under which they may be held liable.

It was stated, inter alia, that the obligation cast upon an AC is not merely towards the immediate company and its shareholders, but to the public and the economy at large.²³ Herein, the independent directors took the defense that they had placed bona fide reliance on reports upon reports received from fellow members of the AC as well as AC reports received from officials of the subsidiaries of FHL. One director, a medical practitioner by profession, also took the defense that he had ‘minimal knowledge of finance and financial statements and that his core area of expertise was medical practice’, similar to the defense taken by the directors in LEEL (supra).

Taking a strict view, the AO found all the independent directors liable, not only for failing to discharge their duties adequately as members of the AC but also for ‘aiding and abetting the scheme of fraud perpetrated by the then management of FHL through their consistent inaction and mechanical approval of the financial statements of FHL.’²⁴

With regards the defense taken by one of the directors as to the minimal knowledge of finance and financial statements, the AO held that if a member of the AC lacks the competence to understand the nuances of high value financial transactions, the same ought to have been brought on record by the concerned member at the time of his/her induction into the AC or the concerned individual ought to have desisted from being a part of the AC.²⁵

It is pertinent to note that in this case the siphoning of funds took place over a long period of time (7 years) over multiple transactions.²⁶ While the independent directors were members of the AC, funds were regularly siphoned out and a significant part whereof was never returned,²⁷ and not a single query/concern was raised on part of the AC members. SEBI imposed a penalty of INR 25 Lakh each on the independent directors in this case.

Contrastingly, in the more recent order of Manpasad Beverages Ltd. (“Manpasand”),²⁸ where the KMP were responsible for misrepresenting the financial statements of the company, the independent directors were held liable only for failing to discharge their statutory duties as members of the AC diligently,²⁹ but not for playing an active role in manipulating the financial statements despite the manipulation happening over a prolonged period of time during their tenure.

II. Independent Directors who are not a part of the Audit Committee:

SEBI’s approach towards independent directors who are not a part of the AC has been more liberal, provided they are able to show that they were not involved in any of the financial wrongdoings of the company. Where preferential shares were issued fraudulently, for instance, the independent director was not held liable upon showing that he was not a part of the Board meetings where the preferential issues were approved.³⁰ Similarly, In Edserv Softare Systems Ltd.,³¹  where the company had fraudulently issued GDRs, the non-executive independent directors were let-off because they were able to show that they raised concerns about the utilization of GDR proceeds with the management in time and resigned from the board subsequently.³²

However, a contrasting approach was taken in the Matter of M/s. MPS Infotecnics Ltd. (“MPS”)³³ Here, the non-executive independent director was tasked by the board with executing an Account Charge Agreement with a foreign bank, which happened to be a part of a fraudulent scheme aimed at misutilization of proceeds from the issue of GDRs. However, the director had no knowledge of the same and signed the document bona fide on behalf of the company.

Despite having no knowledge as to the purpose of the agreement he signed and not having any major role in the decision-making process of the Company, he was held liable under the PFUTP Regulations and was fined to the extent of INR 25 lakh. Among other things, the AO stated that a non-executive independent director has a greater responsibility towards protection of interest of minority shareholders of the Company and cannot claim that he is not “responsible to the company for the conduct of the business of the company”.³⁴

The AO also held that the noticee had the means to understand the fraudulent nature of the transactions being undertaken by MPS, and therefore could not take the defense that he was not aware of the purpose of the agreement when he signed it or that he was merely acting in the capacity of the employee.³⁵ 

SUGGESTED MEASURES FOR INDEPENDENT DIRECTORS:

Drawing from the preceding discussion, a range of caveats arise for individuals assuming roles as independent directors in companies.

• Strong financial proficiency and background: While the Companies Act and LODR regulations outlines the bare minimum financial proficiency in order to become members of the AC, in practice it is apparent that the AC plays a much more nuanced role and a deficiency in one’s ability to read and interpret complex financial statements and transactions can result in default of their statutory obligations. It is now evident that, as a member of the AC, pleading ignorance or lack of financial knowledge or proficiency is no defense to not adequately discharging your due roles. Therefore, it is advisable that if individuals approached to be a member of the AC possess the ability to read and comprehend complex financial statements and must be vigilant with the financial affairs of the company.
• Timely Action: As a member of the AC, it is crucial to actively participate in board meetings and approve the company’s financial statements. Independent directors have the responsibility of making sure that the internal and statutory audits of the company are carried out independently and efficiently. Prompt action is necessary when any financial irregularities arise, and resignation may be considered if satisfactory explanations cannot be obtained from management.
• Mitigating Factors: SEBI adopts a stringent approach regarding AC members’ fulfillment of statutory responsibilities. Exceptions are rarely granted, such as in cases where the member abstained from voting on pertinent board resolutions or when key management personnel (KMP) deliberately withheld financial information from the AC. Continuing association with the company while passively approving questionable financial statements or board actions at the behest of KMPs can result in liability for aiding and abetting financial misconduct. Further, assurances from the promoter that the AC meetings are ‘routine’ or that ‘no experience or knowledge is required for the same’ are of no consequence.³⁶
• Vigilant Behavior: An individual opting not to join membership in the AC may not require the requisite proficiency in finance and accounting. Nevertheless, an independent director is still obligated to exercise vigilance regarding his role within the company. Should the responsibilities entail a deeper involvement in the company’s operations, it is crucial to remain cognizant of the transactions participated in, including understanding the objectives of agreements and contracts that requires to endorse and maintain a general awareness of the company’s affairs. Timely expression of concerns and prompt resignation in instances where management fails to provide satisfactory answers or explanations are imperative actions.

CONCLUSION:

The above discussion is important considering SEBI’s strict approach towards the role of independent directors. In many cases, individuals are approached to join the board upon assurances from the KMP or Promoters that these roles involve minimal responsibility and supervision. Individuals take up these positions only to realize that they are statutorily mandated to fulfill a lot more responsibilities than the ones enumerated to them by the promoters. Even in such cases, no leniency is shown by SEBI to these directors. Penalties imposed by SEBI have ranged anywhere from INR 2 Lakh to INR 25 lakh. This punitive action serves as a deterrent, highlighting the risks associated with corporate governance failures.

It has become important for independent directors to understand their roles and responsibilities better in recent times and act diligently and promptly to shield themselves from liability. The increased spotlight on the role of an independent director is a step towards improved corporate governance.

 
– Maulin Salvi and Sahil Kanuga

You can direct your queries or comments to the authors.

(The authors would like to acknowledge and thank Dev Adwani, Fourth Year, BA.LLB (Hons.), West Bengal National University of Juridical Sciences, Kolkata, for his contribution to this article.)

¹https://www.sebi.gov.in/ enforcement/orders/ apr-2024/final-order -in-the-matter- of-leel-electricals- ltd-_82934.html (“Leel”)

²Ibid., para 120

³Ibid, page 20,21

⁴Ibid., page 65

⁵Ibid., page 20,21

⁶https://www.moneycontrol.com/news/ opinion/wake-up-call- for-independent-directors -after-stiff-penalty-imposed- by-sebi-12708526.html

⁷Companies Act, S.149(6).

⁸Appointment and Qualifications Rules, Rule 5.

⁹Companies Act, S.149(10), S.150(2), S.152.

¹⁰Companies Act, S.149(4).

¹¹Appointment and Qualification Rules, Rule 4.

¹²Companies Act, S.149(6)(d),149(6)(e)

¹³The Companies (Meetings of Board and its. Powers) Rules, 2014, Rule 6.

¹⁴Companies Act, S.177(2)

¹⁵LODR Regulations, Regulation 18(1)(a),18(1)(d).

¹⁶Companies Act, S.177(4)

¹⁷LODR Regulations, Regulation 18(3) r/w Schedule II, Part C.

¹⁸Companies Act, S.177(2)

¹⁹LODR Regulations, Regulation 18(1)(c)

²⁰In the Matter of disclosures by Southern Ispat and Energy Ltd. in respect of its GDR issue, Adjudication Order No. Order/GR/PU/2022-23/16559-16566 (May 26, 2022).

²¹Ibid., at para 62, 63.

²²In the Matter of Fortis Healthcare Limited, Adjudication Order No. Order/GR/KG/2022-23/16420-16458 (May 18, 2022)

²³Ibid. at para 73.

²⁴Ibid, para 77.

²⁵Ibid, para 75.

²⁶Ibid. para 75

²⁷Ibid., para 74, 76.

²⁸In the matter of Manpasand Beverages Limited, Final Order WTM/ASB/CFID/CFID-SEC4/30313/2024-25 (April 30, 2024)

²⁹Ibid, para 55, 56.

³⁰In the Matter of Global Infratech & Finance Ltd, Adjudication Order No. Order/VV/AK/2022-23/18169-18213 (July 29, 2022) para 47.

³¹In the matter of GDR Issue of Edserv Softsystems Limited., Adjudication Order No. Order/GR/BM/2022-23/16742-16747

³²Ibid. at para 66.

³³In the Matter of M/s. MPS Infotecnics Ltd., Adjudication Order No. Order/GR/PU/2022-23/16306 (May 4, 2022)

³⁴Ibid. at para 23.

³⁵Ibid. para 26

³⁶Manpasand, para 54.