Rethinking Independent Directors’ Liability- Towards a Function-based Calibration

The author is Niharika Mukherjee, a fourth year student at National Law School of India University Bangalore.

Introduction

Following a number of corporate scandals in the first and second decades of the 21st century, Indian law has seen a number of radical changes in the liability, duties, and eligibility criteria ascribed to independent directors of companies. While the most prominent tendency in literature analysing these changes is to applaud the narrowing of liability of independent directors for actions of their company, in order to both safeguard them from unfair prosecution and encourage individuals to take up these posts, this article takes exception to this tendency and presents an argument against such blanket easing of norms for independent directors.

To this end, this article shall argue that independent directors’ liability for the acts of a company should vary according to their predominant role in a company’s Board of Directors. In particular, it shall propose that a weaker protection from liability for those primarily engaged in a ‘monitoring role’, compared to those primarily engaged in a ‘strategic advising’ role, is justified.

To this end, it will first briefly describe the provisions on liability of independent directors in Indian law, and highlight two prevailing concerns- one relatively principle-based and the other relatively practical- with them, which it shall label as the ‘onerous and uncertain liability problem’ and the ‘supply problem’, respectively. Secondly, it shall examine the rationales for, and functions of, independent directors in Indian corporate governance. Thirdly, using the conclusions derived from this examination, it shall argue that liability of independent directors should vary depending on the specific functions that the relevant independent director performs as part of a Board of Directors. Fourthly, it shall outline the implications of this argument on the two problems identified earlier. Finally, it shall state its conclusions.

Legal Provisions and Concerns on Liability of Independent Directors

The Companies Act 2013 provides some defences, such as that of having acted ‘honestly and reasonably’ to all directors, in respect of liability for, inter alia, their negligence, breach of duty, misfeasance, or default.

However, for independent directors (as well as ‘non-executive directors’ not being promoters or key managerial personnel), it provides a special ‘safe harbour’ provision in Section 149(12), in respect to acts or omissions of a company- a protection unavailable to other directors. As a result of this, unlike others, these directors can only be held liable for acts or omissions by a company which occurred with their knowledge, which is to be ‘attributable through Board processes’, and with their consent, or connivance, or where they had ‘not acted diligently’. In effect, they are not assumed to be ‘in charge of and responsible to the company’, and hence responsible for its acts- their liability arises only on the basis of their actual (mental) involvement in a specific act by it, in any of the methods specified in the statute. Further, while the Act does not mandate indemnification by companies of their independent directors in respect of liability accrued in relation to the company, the Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements) Regulations 2015 (SEBI LODR) do mandate the same for the top 500 listed entities by market capitalisation.

Despite the above-mentioned safeguard carved out for independent directors, however, two concerns in relation to their liability are highlighted in contemporary literature. The first arises from the argument that, independent directors being aloof from the day-to-day management of a company, are in a ‘singularly vulnerable situation’, and holding them responsible for the acts of the company, in general, places an ‘onerous and unfair’ burden on them. This argument then highlights that Section 149(12) fails to offer sufficient protection to independent directors in practice, despite doing so in its text. This is because, first, these directors are in practice routinely summoned and investigated even in cases where there is no prima facie case of their involvement in the relevant act, and, secondly and more significantly, because courts have, at least in a handful of cases, failed to extend the protection offered by the Section to the director in question. They have taken, instead, what this argument sees as a decision based on the ‘facts and circumstances’ of the case, fraught with the use of discretion, as opposed to simply applying the text of the Section- which is all that the law requires- and often, at an extreme, ignoring the text altogether. This perspective is clearly visible in journalistic reporting as well, such as that on the SEBI’s order dated 31st October 2022 in the matter of Bombay Dyeing and Manufacturing Company Limited.

The second concern draws a causal link between fears of uncertainty in the liability of independent directors (as, possibly, imposed by courts) and an unwillingness of otherwise qualified and capable individuals to serve in this position. This argument draws from empirical research showing that following the introduction of personal liability for independent directors under the Companies Act 2013, individuals can in fact be seen to have been deterred from serving on corporate boards, particularly among companies with greater regulatory risk, higher costs of monitoring, and low monetary incentives. One article concluded that the exit of expert directors resulted in a 1.16% decrease in firm value- leading this argument to suggest, ultimately, a decrease in corporate performance because of the lack of supply of individuals qualified and willing to serve as independent directors, caused by imposition of personal liability on them, and uncertainty regarding how far they will be protected by provisions such as Section 149(12).

For convenience, this article shall term the first problem as the ‘onerous and uncertain liability’ problem, and the second as the ‘supply problem’. It shall return to propose solutions to these in a later section.

Rationale and Functions of Independent Directors

Labelled as a ‘wide-spectrum prophylactic’- in the sense of their potential to treating ‘all agency problems’ while not being ‘exclusively dedicated to any’, independent directors’ roles and functions are far from streamlined, both in corporate governance literature, and in the Indian statute and judicial decisions. It has been noted that in India, in the common context of concentrated shareholding, it is particularly unclear exactly what roles and allegiances independent directors are expected to keep in mind in the course of their directorship. This is in contrast to American and English corporate law, where, in the context of a larger proportion of companies with widely disbursed shareholding, the role of independent directors is more obvious- to safeguard shareholders’ interests from management.

While Schedule IV of the Companies Act 2013 does reflect an effort to clarify the duties of independent directors, the sheer range of activities expected to be performed by them, this article argues, fails to significantly reduce confusion in this respect. For instance, according to the list of duties, independent directors are both expected to offer their judgment on issues of ‘strategy, performance, risk management [and] resources’, and ‘satisfy themselves on the integrity of financial information’ generated in the company. Also, they are expected to ‘moderate and arbitrate’ ‘in the interest of the company as a whole’ in case of conflict between management and shareholders’ interests, while also ‘safeguarding the interests of all stakeholders, particularly the minority shareholders’.

While the latter pair of duties reflects a clear contradiction in terms of allegiance- as safeguarding minority shareholders’ interests appears difficult to reconcile with the neutrality that a ‘moderation’ role would presumably require- a contradiction within the first pair of roles has also been highlighted in literature. This contradiction arises because while a ‘strategic advising’ role builds upon some degree of trust and support being expected from independent directors by management and controlling shareholders, a ‘watchdog’ or monitoring role necessitates these directors to remain distant, even ‘antagonistic’, from the latter. One article has also highlighted that the contradiction may have led to a broader confusion as well- it indicates that while the ‘general public perception’ is that independent directors should serve as ‘watchdogs’, its own findings from interviews with independent directors revealed that the latter see the ‘strategic advising’ function as their predominant role, instead. While highlighted in academic literature, however, neither the Act nor courts appear to address this contradiction- in a recent case, for instance, the Supreme Court itself appointed an independent director, both to look into the financial management and extent of legal compliance of a company, as well as for ‘suggesting steps for good corporate governance’ in the future.

Argument for a Function-based Imposition of Liability

Taking issue with the above, this article argues that the contradiction between the ‘monitoring/watchdog’ role and the ‘strategic advising role’ of independent directors is vital for determining what their liability as far as acts done by the company should be. This is for two reasons, discussed below.

First, the contradiction between the two roles reflects a divergence between two very different objectives sought to be achieved through mandating independent directors to be included in company boards. Out of these two, it is argued that the monitoring role is more important from the perspective of the state’s primary interest in corporate governance- that is, to ensure that business is carried on in a manner that is consonant with financial integrity. The ‘strategic advising’ role is, on the other hand, arguably more important from the perspective of the company’s own productivity, which may be enhanced with well-informed perspectives from outside it. Hence, the primary aim of the liability provision arguably is, and should be, to ensure that independent directors perform their monitoring role effectively- particularly when, as Peter Newman and Reinier Kraakman argue, they have little positive incentive to do this, as they do not, by definition, derive benefits from any particular group of shareholders for performing their role with distinction, or have any material pecuniary stake in the performance of the company. As the degree of neutral, expert advice on business matters available to a company is not the state’s concern- at least, not directly- the law should be significantly less concerned as to how these roles are performed.

Secondly, it is highlighted that the two roles require very different levels of engagement with the company’s financial information, in order to be performed efficiently. On the one hand, a ‘strategic advising’ role, it has been noted, may require only a ‘limited and discrete’ time commitment in engaging with company-related information, and is dependent to a far greater degree on expertise and experience gained by the director outside of the company. On the other hand, the ‘monitoring’ role is dependent on exposure to this type of information- at the very least, for instance, information about the existence of a transaction, such as a potentially ‘self-dealing transaction’ or ‘minority freeze-out transactions’, that may hurt minority shareholders’ interests, or amount to fraud. This type of information is also frequently provided to independent directors, in practice, through membership in ‘audit committees’ of companies. Hence, a ‘strategic advising’ role is much less dependent on the independent director taking the effort to peruse company information, than the ‘monitoring role’ is- and therefore, to place this burden upon the former is difficult to justify.

While the degree of information actually available to independent directors for the ‘monitoring’ purpose- specifically, the lack thereof- is a subject of criticism, this article uses the above proposition, along with the first, to argue that there is some basis to suggest that, given the existence of a contradiction between the two roles played by independent directors, their liability should differ with the role predominantly being played by them on a given company board. Phrased differently, an independent director appointed mainly for the purpose of the company benefiting from their business acumen should not be subject to the same liability framework as one appointed predominantly for their contributions to monitoring of the company.

Implications of a Function-based Liability

Having argued for the soundness of the above position even while recognizing that it deviates from the law as it stands at present, this article shall now reflect on the implications of its argument on the ‘onerous and uncertain liability’ problem and the ‘supply’ problem noted earlier.

On the ‘Onerous and Uncertain Liability’ Problem

As argued in the immediately preceding section, the lessened information asymmetry faced by independent directors playing a ‘monitoring role’ through an audit committee provides basis- along with their existing lack of positive incentives to play this role effectively- to argue that imposing liability upon them for acts of the company, without the additional protection of Section 149(12), may be not be unjustified, in terms of principle. The ‘uncertainty’ in how courts have applied it may also be lessened with the insight suggested above.

To tackle the problem in practice, however, this article suggests that companies would be well-advised to clearly delineatethe ‘roles and positions’ of each of their independent directors, at the outset. For this purpose, Codes of Conduct drawn up by companies for independent directors, as required under the SEBI LODR 2015, may include details of the primary responsibilities of each director, including, for instance, specifically whether they are there for ‘strategic advising’ purposes or ‘monitoring’ purposes. Secondly, companies may also ensure that independent directors brought only, or mainly, for the ‘strategic advising’ objective, may be exempted from serving on audit committees, to prevent them from being deprived of the ‘safe harbour’ protection, like the independent directors in the recent decision of the Securities and Exchange Board of India (SEBI) in its order dated 31st October 2022 in the matter of Bombay Dyeing and Manufacturing Company Limited.

On the ‘Supply’ Problem

Admittedly, the argument for a function-based liability does not fully solve the ‘supply’ problem- it arguably worsens it for independent directors sought for playing the ‘monitoring’ role.

While recognizing that this problem remains, this article makes two suggestions. First, while its argument, if incorporated into the law, would worsen the ‘supply’ problem for directors sought for the ‘monitoring role’, it would arguably alleviate it for those sought for a ‘strategic advising’ role, particularly if companies take the above-suggested precautions to clearly demarcate responsibilities. Secondly, it recognizes empirical observations that the imposition of personal liability has increased measures taken by independent directors to ensure proper monitoring. In view of this finding, it urges that reducing liability for directors engaged in monitoring tasks is not the solution to the ‘supply problem’- that, in effect, would simply incentivize individuals uninterested in performing this task diligently to seek to serve in this position. A possible solution, rather, is that companies should ensure that independent directors brought in to serve the ‘monitoring role’ are well-equipped to do this. One of the ways to do this, this article suggests, without imposing unrealistic expectations upon managers and controlling shareholders, is to, as also stated above, simply ensure that all independent directors appointed (predominantly) for this purpose are placed in audit committees. This would have the important advantage of minimizing the information asymmetry suffered by independent directors tasked with this- a common grounds for fears of independent directors regarding their liability.

Conclusion

This article has recognized the concern that while the text of Section 149(12) of the Companies Act 2013 offers a ‘safe harbour’ to all independent directors against liability for acts done by the company, adjudicating bodies have failed to apply this protection in a consistent manner. Drawing from this, it has, apart from suggesting that the provisions on liability be amended to incorporate such a differentiation, suggested that companies must ensure clarity in the roles expected of individual independent directors and either place, or not place, them in specialized committees, on the basis of such role demarcation. This, it is concluded, will both help companies and independent directors to protect against unwarranted impositions of liability in the current- uncertain- legal framework on the same, as well as have the more generally beneficial effect of fostering clear and focused mandates for independent directors in practice- thus helping them to play an effective role in corporate governance.