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May 10, 2024
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.
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