SEBI proposes stringent guidelines for IDs in a listed company

-Independence becomes stricter!

Payal Agarwal | Executive (corplaw@vinodkothari.com)

Introduction

The concept of independent directors was first introduced in the Desirable Corporate Governance Code issued by the Confederation of Indian Industry[1] followed by the recommendation in the Corporate Governance Committee constituted by SEBI and headed by Mr. Kumar Mangalam Birla[2] (Kumar Mangalam Birla Committee). Later in the year 2000, SEBI incorporated the recommendations of the Kumar Mangalam Birla Committee under Clause 49 of the Listing Agreement[3]. Independent directors have always been regarded as the means to strengthen the corporate governance framework in a public or a listed company.

 

Keeping in mind the intent of the lawmakers to introduce the requirement for having Independent Directors (IDs) on the board of certain companies, it is understood that SEBI cannot accept a situation where the IDs themselves turnout to either be ineffective for strengthening the corporate governance or act against the interest of the public shareholders. Therefore, with the intent to further strengthen the role and responsibility of IDs, SEBI has introduced a Consultation Paper[4] (Paper) on review of regulatory provisions related to IDs on 2nd of March, 2021. Through this Paper, SEBI has proposed to make stringent regulatory changes in the provisions of the Listing Obligation and Disclosure Requirements Regulations (LODR/ Listing Regulations) relating to

  • eligibility criteria of IDs,
  • role of Nomination and Remuneration Committee (NRC),
  • composition of Audit Committee (AC) and Nomination and Remuneration Committee (NRC)
  • appointment and removal procedure of IDs

The Paper is open for public comments till 1st April, 2021.

This write up critically covers the proposed changes and discusses on the proposed impact of on the working of a company including the corporate governance aspects.  The proposed changes are discussed below under the relevant heads.

1.      Widening the criteria for independence

Currently, Regulation 16(1) of the Listing Regulations provides the definition of “independent director”. SEBI proposes to broaden the criteria of “independence” by expanding the outreach of the restrictions given under the said Regulation and at the same time standardising the cooling off period provided therein.

The Paper proposes two amendments in the independence criteria of IDs in addition to the extant definition:

  • KMPs and employees of companies falling under the promoter group of the listed entity & relatives of such KMPs should not be eligible to act as an ID until a cooling off period of 3 years has passed.

This will be in addition to the existing fetter on the KMP and employee of the listed entity, its holding, subsidiary or associate company.

  • Another proposed amendment is with regard to increasing of the cooling-off period in Regulation 16(1)(iv) and Reg 16(1)(v) of the Listing Regulations.

Currently, the Regulations specify a cooling-off period of 2 years in case of material pecuniary transaction between a person or his relative and the listed entity or its holding, subsidiary or associate company. This is proposed to be increased to 3 years to make it similar to the other provisions of Regulation 16 where a cooling-off period of 3 years is required to be satisfied.

Rationale behind the proposal:

This proposal aims to make the independence criteria more broad so that there is no way by which the promoter group entities can take undue benefit due to any loopholes in the language of law.

On the other hand, the proposal for increasing the cooling off period is for making the same uniform all through the independence criteria.

2.       Dual voting approach introduced for appointment / re-appointment /removal of IDs

The Paper proposes to bring a major change in the procedure of appointment/ re-appointment as well as removal of IDs. Here, let us mention that the IDs are required to be recommended by NRC before their appointment is approved by shareholders in the general meeting. In the present scenario, the IDs are required to be appointed by way of a shareholders’ resolution by simple majority. In case of re-appointment, a special resolution is required to be passed by the shareholders.

  • The proposed procedure for such appointment/ re-appointment is via “dual approval” from shareholders, as follows:
  • An ordinary resolution by shareholders (Special Resolution in case of re-appointment) and
  • A resolution by “majority of minority”

(Note: The Paper defines minority shareholders to mean shareholders other than the promoter and promoter group.)

In a situation where either of the two resolutions fail, the company may either propose another person as ID, or put the same proposal for a second vote

  • Such second vote can be done only after a cooling period of 90 days but within a maximum period of 120 days
  • Such second vote should be passed by a special resolution in which all shareholders can take part
  • Further, the proposal makes the requirement of shareholder’s approval a pre-condition for every appointment of ID.
  • In cases of any casual vacancy of IDs, the Listing Regulations currently provides a time period of upto 3 months or next Board Meeting, whichever is later, for filling up the vacancy. SEBI proposes to limit the time upto 3 months from such vacancy to appoint another ID.

A similar concept of dual voting approach has been prescribed by SEBI for the removal of IDs as well.

Rationale for such proposal

SEBI has, in its consultation paper, specified that the present system of appointment of IDs may be influenced by the promoters – in recommending the name of ID and in the approval process by virtue of shareholding. This may hinder the “independence” of IDs.

Additionally, considering that the primary duty of IDs is to protect the interest of minority shareholders, there is a need for minority shareholders to have greater say in the appointment / re-appointment process of IDs.

Therefore, SEBI has proposed the “dual approval” model in line with the legislative requirements of Israel and UK, especially in interest of the minority shareholders.

Since, the ID may be removed through a simple majority, the promoter may have significant influence in the removal process by virtue of shareholding. So, the “dual approval” model has been proposed to be extended to govern the removal of IDs as well.

Further to this, the requirement of approval of shareholders as a precondition before appointment of any ID is pursuant to the current practice, wherein an ID is appointed as an additional director by the Board of a company, to be subsequently ratified by the shareholders in the ensuing AGM. Such a practice creates a significant time gap between the appointment of an independent director and approval of shareholders, which is not in the best interest of especially the minority shareholders. Therefore, SEBI seeks to do away with this time lag by inserting the requirement of prior approval of shareholders.

3.       Resignation of IDs

Through the Paper, it becomes clear that the intention of SEBI is to strictly monitor the resignation of the IDs where the real cause of resignation should be clearly known in place of the apparent cause the company and ID may try to show.

The Paper provides for a cooling off period of 1 year in two cases:

  • Where the ID resigns on account of discretionary reasons of pre-occupation, other commitments or personal reasons – Mandatory cooling period of 1 year before joining another Board as an ID;
  • Similar cooling period of 1 year in case of transition from ID to WTD in the same company.

Further, the Paper also proposes that the complete resignation letter of the outgoing ID needs to be disclosed to the stock exchange.

Rationale for such proposal

The cooling off period of 1 year before transition of an ID as a WTD in the same company has been proposed to ensure there is no compromise in the independence of the director during his term as an ID.

It is observed that IDs often resign for reasons such as pre-occupation, other commitments or personal reasons and then join the boards of other companies. There is, therefore, a need to further strengthen the disclosures around resignation of Independent Directors.

4.       Role of NRC in selection of candidates for the role of ID

The NRC is required to recommend the persons to be appointed as IDs in the board of the company. Though the Listing Regulations already requires the NRC to formulate criteria regarding such appointment, the role of NRC, in practice, does not suffice the intent of law properly. Therefore, vide the Paper, SEBI has prescribed the following procedure for selection of candidates for the role of NRC.

  • Evaluate the balance of skills, knowledge and experience
  • On the basis of above evaluation, prepare description of required roles and capabilities required for that particular appointment of ID
  • Identify the suitable candidate fitting the said description
  • For identifying persons, NRC may
    • use services of external agencies
    • May consider candidates from wide variety of backgrounds ( for diversity)
    • And consider time commitment of appointees
  • The person identified and recommend to the Board should possess capabilities as per description.

Rationale for such proposal

While the law requires NRC to lay down detailed criteria of qualifications and attributes for directors, apparently there is a lack of transparency in the process followed by NRC. There is therefore, a need to prescribe disclosures regarding the process followed by NRC for selection of candidates for the post of ID.

5.       Modification in composition of NRC and AC

The Paper also seeks to bring in some changes in the constitution of NRC and AC. The following changes are proposed to be made:

  • NRC to comprise of 2/3rds of ID ( presently alteast one-half IDs required)
  • AC to comprise of 2/3rds of IDs and 1/3rds of Non-executive directors(NED) that are not related to promoter (presently, the AC requires atleast 3 members of which atleast 2/3rds shall be IDs)

Rationale for such proposal

Considering the importance of the Audit Committee with regard to related party transactions and financial matters, it is proposed that audit committee shall comprise of 2/3rd IDs and 1/3rd Non-Executive Directors (NEDs) who are not related to the promoter, including nominee directors, if any.

6.       Enhanced disclosure requirements

The Paper proposes various sorts of enhanced disclosures under different headings. Disclosures leads to transparency which is an important principle to be kept in mind under the arena of corporate governance. The various proposed disclosures has been discussed below:

  • Appointment/re-appointment/ removal of ID subject to second voteNotice calling shareholders’ meeting shall specify reasons for second vote on the same proposal despite failure of the first resolution.
  • Notice for appointment of IDThe notice calling a meeting of shareholders for the purposes of appointment of an ID shall disclose the following:
    • skills and capabilities required for the role;
    • how the proposed appointee fits the role;
    • Channels for searching appropriate candidates
    • Category of person who have recommended the name (in case of recommendation by person)
  • Disclosure on resignation of IDsWhere an ID resigns from a company, the entire resignation letter along with a list of present directorships and members in committees needs to be disclosed to the stock exchanges.

7.       Remuneration of IDs

The consultation paper has made various proposals in relation to the remuneration of IDs. The proposals include the following:

  • Removal of profit-linked commission
  • Increase in sitting fees
  • Issue of ESOPs with long vesting period

Rationale for such proposal

The removal of profit linked commission and increase in sitting fees is proposed with a view that the remuneration to IDs should be on the basis of their value and time-commitments to the company, without linking the same to the profits of the company. This would lead to IDs getting a fixed fee, without having any stake in the long-term growth of the company.

The concern with this approach – that profit or performance linked commission may encourage short-termism and lead to conflicts, may be addressed by permitting ESOPs to IDs (instead of profit linked commission) with a long vesting period of say, 5 years.

Our analysis on the removal of profit-linked commission and substitution of same with ESOPs has been dealt with in our other article and may be referred.

 

Conclusion

The proposed changes are extremely significant and will have a remarkable impact on the corporate governance of listed entities. While on one hand, more transparency may be achieved by means of amendments like enhanced disclosure on resignation, appointment, selection of candidates as IDs, etc, however, proposal relating to dual voting may not serve to achieve the purpose due to the presence of the option for second round of voting. Of all, the proposals seek to check the interference of promoters at all levels of corporate governance and ensures much more independence to the IDs where the IDs will be independent in both letter and spirit. However, in some areas, the proposed requirements seems to be very much stringent, which may hinder the idea of “ease of doing business”.

 

[1] http://www.nfcg.in/UserFiles/ciicode.pdf

[2] http://www.nfcg.in/UserFiles/kumarmbirla1999.pdf

[3] https://www.sebi.gov.in/legal/circulars/feb-2000/corporate-governance_17930.html

[4] https://www.sebi.gov.in/reports-and-statistics/reports/mar-2021/consultation-paper-on-review-of-regulatory-provisions-related-to-independent-directors_49336.html

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