August 2005

insight

Independent Directors Are they watchdogs

for good governance?
Analytical Contact : Revathy Sreedharan

revathy@crisil.com

The Board of Directors comprises elected representatives of the

shareholders of a company. Thus, the Board is responsible for
governance, decision- making, and oversight of a companys
operations, to ensure protection of the long- term interest of the
shareholders. To fulfil this role effectively, the Board has to be
independent and experienced, and have access to efficient resources.
Independence is a crucial aspect of good governance but it is not the
end in itself. It is the effort and commitment of the entire Board that
leads to good corporate governance and result in creating sustainable
value for shareholders in the long run.
The J.J. Irani Committee report on Company Law has made a number
of recommendations for a Boards composition and functioning with
an eye on improving the standards of corporate governance while
recognising the diversity and the nature of the functioning of Indian

August 2005
companies. This article explores the issue of a Boards independence.
It attempts to answer questions on how much independence a Board
should have, how the role of independent directors is evolving, and
how a company can benefit from independent directors.
A Boards independence implies the degree to which its members are
non-biased and free from control by the management or other
influential groups. A Boards independence is vital for effective
functioning of a company, since it leads to unbiased decision making,
which benefits the shareholders. One way to achieve this independence
is to induct independent directors on the Board. Independent directors
bring with them specialised knowledge, skills, experience, and an
unbiased perspective of the companys business. The quality and
effectiveness of the Board depend greatly on the value that independent
directors bring with them. This value could be in terms of objectivity to
the Boards functioning, questioning of the managements intent and
promotion of healthy and meaningful discussions during Board
meetings.
Though it is extremely important to have independent directors on the
Board, it is also essential to realise that they are not solely responsible
for the effective and unbiased functioning of the Board. It is the
responsibility of the entire Board to make sure that the company is
being run in keeping with the best corporate governance practices. The
members, whether independent or executive, need to bring to the Board
their professional expertise and work with the goal of improving
shareholder wealth over the long term.
How much independence leads to good governance?
A Board needs to have the right mix of directors who, as a collective
body, are able to govern the company effectively. The shareholders
and a companys Board are most equipped to decide the right mix of
directors. No single code, guideline, or regulation can accurately
determine the right mix for all companies. This is because every
company is unique in size, operations, growth objectives, and
ownership pattern. This, however, does not mean total flexibility and
freedom without responsibility and accountability. Regulation has to
ensure that a certain framework is in place, so that companies can
operate within that framework while having flexibility in deciding the
Boards structure and composition.
Undoubtedly, listed companies should have independent Board
members, since this leads to better Board functioning, imparting
independence. The moot point is how many independent directors a
company should have. Should the shareholding pattern, ownership of

the majority shareholders, or the nature of the chairman decide the

number? To answer this question, it is essential to take a closer look at
the purpose of having a Board and independent directors.
The shareholders elect a Board; so, in accordance with the philosophy
of a joint stock company, a Board should have proportional
representation of shareholders. However, if one strictly enforces
proportional representation, then, in most cases, the voice and interests
of the minority shareholders will not be heard. Hence, there is the need
for a reasonable representation of independent directors who have an
objective view of the working of a company.
The Irani Committees proposal to have a minimum of one-third of the
total number of directors as independent is adequate and appropriate
for all public listed companies. The actual number of independent
directors can be decided by the companies, depending on the expertise
needed at the Board level subject to a minimum of one-third.
The Irani Committee further states that the number of independent
directors should not depend on whether the chairman is executive or
not, which is the current legal prescription. Traditionally, in the Indian
context, it is seen that the chairman plays the executive role and is the
main promoter or representative of the largest shareholder of the
company. On the other hand, a non-executive chairman is usually
present in cases where the shareholding is fairly dispersed; an instance
of this would be where the largest shareholder holds only around 1525 per cent of the companys equity stock. Going by the logic of
proportionate representation of shareholders, a high number of
independent directors is found only in case of such widely held
companies. Thus, stipulating a requirement that a company with an
executive chairman should have a higher number of independent
directors is not realistic. The number of independent directors need not
be linked to the nature of the chairman, as long as the requirement of
one-third independence is strictly implemented.
In brief,

All Boards need not have majority independent directors

A requirement of one-third of independence is adequate for listed
companies

The number of independent directors need not depend on the

nature of the chairman

The shareholders of a company are in the best position to

determine the number of independent directors on its Board,
subject to a minimum of one-third.

August 2005
Spirit of independence Enforcement is a challenge
The Irani Committee has rightly defined the qualities and the attributes
of independent directors in detail. The definition of an independent
director, though more than illustrative, is not exhaustive. In reality,
there could be instances of a director complying with all the
requirements of this definition, but still not functioning as an
independent director. For example, an ex-employee who has retired
from a company a year back may still have preferences and linkages
with the management. Again, in the case of a joint venture company,
an ex-CEO of a joint venture partner who is appointed as an
independent director after a year may still act in concert with the other
directors representing the joint venture partner on the Board. Three
themes arise from this discussion:

A cool-off period of one year for an ex-employee and audit / legal

firm employee may not be sufficient; a three-year period would be
more realistic

A regulatory or independent agency should have the right to

to protect the interests of the institution that has lent to or invested

substantial monies in the company.
The same logic can be extended to Government nominee directors. In
case of public sector units (PSUs), nominee directors of the Government
primarily convey the Governments viewpoints on various matters.
Indeed, SEBI, as per the Clause 49 agreement that deals with corporate
governance of listed companies, has recently clarified that Government
nominees on the Boards of PSUs cannot be treated as independent
directors.
How to make the best of independent directors?
Independent directors could be an extremely useful resource in guiding
and governing a company as per the best interests of the shareholders.
The performance and successful participation of an independent director
depends on a number of factors such as:

Qualification, background, and relevant experience of the

independent director

examine the independence of the directors, if and when required

Age, personality, and stature of the independent director

Further, meaningful penalties should be imposed for wrong

Nature of the chairman of the Board

declarations/ classification of independent directors

Quality and nature of the other Board members

The process of identification and appointment of an independent

director itself could provide hints about the likelihood of a person
acting independently. A good way to identify and appoint an
independent director is to involve a nominations committee of the
Board, or involve the entire Board. This will ensure that prejudices and
proximity to management, or a majority shareholder, do not influence
the selection of independent directors.

Nature of interaction of the Board members at the Board meeting

and otherwise

Induction process of independent directors this will determine

the lead time taken by the director to start making meaningful
contributions during the deliberations at the Board meetings

Remuneration given to the independent director

A significant recommendation of the Irani Committee pertains to the

treatment of institutional nominee directors. The committee classifies
institutional nominees as non-executive and non-independent
directors. This is a drastic change from past practices. All codes,
guidelines, and provisions of listing agreements have so far classified
institutional nominees as independent directors. The present
recommendation of the Irani Committee reflects current realities and
is thus a welcome step. The nominees do not bring forward
independent viewpoints while participating at the Board meetings.
More often than not, they put forward views of the institution that they
represent; in many instances, institutions have a formal system of
recommending and recording these views. Hence, the institutional
nominee directors are not truly independent. They are usually present

While many will agree on most of the points above, the most likely
disagreement will be on the point of remuneration. The common belief
is that the lower the remuneration from a company, the higher the
level of independence of a director. On the other hand, it may be
argued that unless a reasonable monetary benefit is promised to
independent directors, a company may not be able to attract the best
talents, despite the popularity and performance of the company.
Remuneration becomes a significant factor, especially since the
company stands to benefit from the valuable executive time of the
respective director. As long as the compensation from a company
does not infringe on the concept and practice of independence, there
should be no ceiling on issues like sitting fees. However, there could
be an overall ceiling on the compensation (including stock options,

August 2005
performance linked benefits, shareholding, etc.) to independent
directors, which can be decided by the company itself and stated
upfront in the public domain. A company and its shareholders are
best suited to decide this ceiling, which should be disclosed adequately
in the public domain.
Another significant tool to motivate and get the best out of independent
directors is to assess the role and contribution of the directors towards
the Board and the company they serve. The nature of self-assessment
or peer group assessment could be designed to ensure the attainment
of the objective, without causing embarrassment to the directors. When
an independent director has to actually record his contribution and
effective participation at Board meetings, he or she will most certainly
be motivated to do more and will emerge as a better director.
The changing role of independent directors
The nature and extent of association of independent directors with the
company makes their role very different from that of executive directors.
This brings about a distinction in the rights, duties, and liabilities of
an independent director. Having said that, it is appropriate to look at
the way the role of independent directors has been changing in the
recent past ever since corporate scandals broke out in U.S.A., Europe,
and other parts of the world. Greater responsibility is being vested in
them from the corporate governance angle. The responsibilities include:

Protecting the interest of minority shareholders by ensuring that

the Board decisions do not favour any particular set of
shareholders or stakeholders

Bringing credibility to the Boards processes

Ensuring independence of the Board during decision-making

Questioning management decisions and carrying out effective

oversight

Acting as a check for the various decisions taken by the

management and majority shareholders

Participating in various Board committees and highlighting the

aspect of independence.

Clearly, the extent of involvement of an independent director in the

decision-making process of a company is increasing; this is a positive
development. This will enhance the position and role of independent
directors, as they will be viewed with more seriousness. Having said
that, it is important to note that excessive pressure is being put on
independent directors to play the role of sole caretakers of corporate
governance. Independent directors are being considered as watchdogs
of corporate governance. Moreover, the functioning of other directors,
who are making significant contributions and have been responsible
for the growth and functioning of the company, is sometimes being
forgotten.
For successful Board functioning, all directors need to be accorded
equal importance. Each director, independent or non-independent, has
a distinct role to play in the functioning of the Board. Corporate
governance principles and theories should not impose any artificial
hierarchy on the Boards. Each company and its respective Board
should formulate most efficient and unbiased way to govern their
company and should not fall prey to unrealistic hypotheses and
theories.
Conclusion
Independent directors are essential to bring about good corporate
governance. As the role of independent directors has evolved over
time, they have become crucial to Board functioning and corporate
governance. Successful and well-governed companies invariably
identify the right candidates as independent directors and derive the
maximum benefit from their association. However, it is also important
to keep in mind that good governance is not just the outcome of
efficient functioning of the independent directors. It is the effective
functioning of the entire Board of directors that can bring about the
best corporate governance practices and benefit shareholders, in the
long term.