Background and Introduction
An “independent director” (“ID”) is defined as “an independent director referred to in sub-section (6) of section 149”,[1] where Section 149(6) of the Companies Act, 2013 (“Act”), clarifies that an ID is “a director other than a managing director or a whole-time director or a nominee director” of the company. To be appointed as an ID, a person must fulfil an elaborate set of objective and subjective criteria separated across equity unlisted and listed companies.
For appointment as an ID in an equity unlisted company, the person should fulfil the criteria stipulated under Section 149(6) of the Act and Rule 5 of the Companies (Appointment and Qualification of Directors) Rules, 2014 (“Appointment Rules”). On the other hand, since an equity listed company would be additionally regulated by the Securities and Exchange Board of India (“SEBI”) and the Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements) Regulations, 2015 (“SEBI LODR”), the ID to be appointed would have to comply with the higher regulatory threshold prescribed under the SEBI LODR, specifically under its Regulation 16(1)(b), in addition to meeting the requirements and compliances stipulated under Section 149(6) of the Act. Despite conducting a rigorous background check and process beforeappointing an ID, the company must also consider certain conditionalities from the governance perspectives when appointing or reappointing such an ID to the board. In this blog, we evaluate the sufficiency and necessity of the governance considerations in light of the extant legal requirements regarding the appointment or reappointments of IDs to the board.
Evaluating the legal embargos on the appointment of an ID for any directorship with the company
Appointment as an ID for three consecutive terms
Although a person appointed as an ID would continue to have to fulfil all the aforementioned criteria for the duration of the directorship and to qualify for appointment as an ID for consecutive terms, Section 149(11) of the Act stipulates the following additional embargos on the re-appointment of an ID beyond two consecutive terms:
“Notwithstanding anything contained in sub-section (10), no independent director shall hold office for more than two consecutive terms, but such independent director shall be eligible for appointment after the expiration of three years of ceasing to become an independent director:
Provided that an independent director shall not, during the said period of three years, be appointed in or be associated with the company in any other capacity, either directly or indirectly.
Explanation.—For the purposes of sub-sections (10) and (11), any tenure of an independent director on the date of commencement of this Act shall not be counted as a term under those sub-sections.”
According to Section 149(11) of the Act, the restriction on the appointment of an ID specifically applies only if the ID in question was being reappointed as an ID; the provision merely clarifies that an ID who has already served two consecutive terms in the same capacity would have to undergo a three-year cooling-off period before being eligible for reappointment as an ID by the company.
As the appointment of a non-ID has no similar cooling-off period requirement, no restrictions apply to a director who has served one term as an ID and another in the capacity of a nominee director. The requirement for a cooling-off period is triggered only if the third consecutive directorship is to continue as an ID (after previously completing two terms as an ID).
Appointment of an ID as an executive director
Separately, in relation to an equity listed company, Regulation 25(11) of the SEBI LODR expressly stipulates that “No independent director, who resigns from a listed entity, shall be appointed as an executive / whole time director on the board of the listed entity, its holding, subsidiary or associate company or on the board of a company belonging to its promoter group, unless a period of one year has elapsed from the date of resignation as an independent director”.
Evaluating governance concerns in relation to continuing an ID’s directorship from a proxy advisory perspective
Proxy advisory firms[2] provide voting recommendations on proposals that certain equity listed entities take up for shareholder approval. The relevance and importance of proxy advisory firms in India is still on the rise; however, unfortunately, currently most proxy advisory firms have adopted Western governance standards and thereafter codified a governance threshold, which may be suitable from a Western corporate governance perspective but may not work for the Indian market currently.[3] Further, more often than not, the governance thresholds used by proxy advisory firms are higher than legal requirements since these standards are not legally mandated or required, implying that these effectively push the threshold of governance standards.
Pertinently, their prominence is on the rise, as certain institutional shareholders have indirectly outsourced their decision making on shareholder resolutions to such proxy advisory firms, as they have internal policies that require them to vote in accordance with the recommendations of the proxy advisory firms. While the institutional shareholders have mechanisms to allow their voting recommendations to be different from the proxies’ recommendations, they will have to provide detailed reasons for voting differently, impliedly making it more challenging for them to vote the other way. This is often a bigger concern for professionally managed companies or companies with very high public shareholding as the public shareholders tend to vote in line with the recommendations by the proxies. The consequential impact of proxy recommendations increases when the law requires only public shareholders/non-related parties to vote in relation to certain matters and, in other cases, places an embargo on the promoters/related parties to vote, given that the foreign institutional investors (“FIIs”), domestic institutional investors (“DIIs”), and other public shareholders are likely to vote in line with the recommendations of the proxy advisors. Recently, shareholders of a listed company rejected the appointment of two IDs after some proxy advisory firms recommended voting against such appointment.[4]
Appointment for consecutive terms as an ID
Proxy advisory firms generally hold a stringent view on the reappointment of IDs who have already served 10 years or more as a director or have been associated with the company or its group for 10 years or more, maintaining that such directors should not be considered for reappointment without completing a cooling-off period after leaving the board of directors. The rationale for this position is that an association extending for 10 years or more could potentially compromise the director’s independence and objectivity. Further, proxies believe that serving an extended tenure can create an impression that the ID has developed some comfort with the company; therefore, any subsequent extensions to their directorship could be indicative of such comfort and a vitiation of “independence”. They also believe that an ID’s reappointment as a non-ID during the ID term could be perceived as making a promise while still serving as an ID, thereby compromising “independence”. While, conceptually this makes sense, applying this as a universal rule without context can lead to unintended consequences, especially in a company with a board mostly comprising IDs.
For example, a tech company’s board comprised six directors – four IDs, one a managing director, and one a non-independent non-executive director (“NINED”), none of whom were promoters or belonged to the promoter group. The proxies recommended against a resolution to appoint as NINED one of the IDs who had already served 10 years as a director in the company even though this re-designation would leave the board with three IDs, one managing director, and two NINEDs – 50 per cent of the board composition would remain IDs.
Cooling-off period for IDs
SEBI first proposed the inclusion of a cooling-off period for IDs before they could transition from an ID to a whole-time director (“WTD”) in its Consultation Paper on Review of Regulatory Provisions related to Independent Directors dated March 1, 2021. SEBI’s Primary Market Advisory Committee (“PMAC”) subsequently considered this and recommended that IDs be permitted to transition to the role of an executive director or a WTD and any cooling-off period requirements be removed. However, subsequently, SEBI differed with this view stating that “… while PMAC has recommended against the proposal, it is felt that a cooling-off period would reduce potential impairments to an independent director’s impartiality in decision-making in instances where an ID knows that he/she may move to a larger role in the company in the near future. It is therefore proposed to go ahead with the proposal. It may also be clarified that this provision would be applicable in case of transitioning to WTD in the same company/ holding/subsidiary/associate company or any company belonging to the promoter group.”[5] To this end, SEBI amended the SEBI LODR to include Regulation 25(11), which was to be effective from January 1, 2022.[6]
Regulation 25(11) of the SEBI LODR stipulates that any ID who has resigned shall not be eligible for subsequent appointment as a WTD/executive director of the “listed entity, its holding, subsidiary or associate company or on the board of a company belonging to its promoter group, unless a period of one year has elapsed from the date of resignation as an independent director”.
Some proxy advisory firms are of the view that there should be a mandatory cooling-off period after the cessation of tenure as an ID with the company for an ID being reappointed for any other directorship with the company. To this end, some proxy advisory firms believe that the aforementioned embargo under Regulation 25(11) of the SEBI LODR should be read to apply to NINEDs as well. This view leads to some proxy advisory firms giving negative recommendations on the appointment of any ID as an executive director/NINED, unless the person has served a mandatory one-year cooling-off period. Pertinently, if this view were to be extended, it could be argued that any person who has once served as an ID for a company should also not be permitted to be employed with the company without serving a cooling-off period as opposed to just restricting them from directorships.
Analysing the need for IDs to have an “independence” check for being appointed as non-IDs
Any person who has firstly been appointed as an ID has by necessary implication fulfilled the objective and subjective criteria for qualifying as an ID, which includes an assessment of fit and “independence”. Given this, if this person were to be appointed as a non-ID, it does not seem logical to oppose the directorship solely on the grounds of loss of “independence” because of continued engagement with the company, given that the reappointment is only for a non-ID role.
In any event, an ID being appointed subsequently as a non-ID would still be bound by all the obligations on a director pursuant to Section 166 of the Act, which include an obligation to “act in good faith in order to promote the objects of the company for the benefit of its members as a whole, and in the best interests of the company, its employees, the shareholders, the community and for the protection of environment” and “exercise his duties with due and reasonable care, skill and diligence and shall exercise independent judgment”.
Conclusion
Governance thresholds of proxies are not relevant for equity unlisted companies; however, it is essential that apart from compliance with the legal and regulatory requirements, equity listed companies also consider the guidelines of proxy advisory firms to ensure that they can mitigate any potential impact of proxies flagging too many issues and the resultant failure of resolutions proposed by the company. This becomes more significant when the company does not have excess IDs. If the appointment of a proposed incoming ID fails, the board will have to immediately scramble and look for an alternative ID in a world where finding competent and willing persons to serve as IDs is already difficult. This could hamper the board’s ability to function in the interim.
To remedy for and mitigate this, it would always be beneficial to share clear and detailed reasons in the explanatory statements where, among other things, the company can call out the detailed rationale of why the director in question is required to be brought back to the board in a different capacity; highlight their skills, experience and achievements; discuss the overall board independence; and also proactively work towards making (to the extent commercial practicable) disclosures expected by proxy advisory firms.
For further information, please contact:
Bharath Reddy, Partner, Cyril Amarchand Mangaldas
bharath.reddy@cyrilshroff.com
[1] Section 2(47) of the Act.
[2] Proxy advisors are defined under Regulation 2(p) of the Securities and Exchange Board of India (Research Analysts) Regulations, 2014 as “any person who provides advice, through any means, to institutional investor or shareholder of a company, in relation to exercise of their rights in the company including recommendations on public offer or voting recommendation on agenda items”.
[3] To read more on the impact of proxy advisory firms, check out our blog here – Impact of Proxy Advisory Firms: Turning tides and failing resolutions | India Corporate Law
[4] Relevant news reports accessible here and here.
[5] SEBI’s memorandum on ‘Review of Regulatory provisions related to Independent Directors’, accessible here – https://www.sebi.gov.in/sebi_data/meetingfiles/jul-2021/1626155485805_1.pdf
[6] Amendment to the SEBI LODR dated August 3, 2021, accessible here – https://www.sebi.gov.in/legal/regulations/aug-2021/securities-and-exchange-board-of-india-listing-obligations-and-disclosure-requirements-third-amendment-regulations-2021_51719.html
