Independent directors are essential to ensure objectivity in corporate governance. They safeguard minority interests and maintain internal checks and balances. However, press reports reveal that independent directors are resigning owing to increased responsibilities on account of tighter regulation and stricter compliance norms. Recent rulings by the Securities Appellate Tribunal (SAT) also prove that the responsibilities attached to their positions have increased.
In Vishal Ahuja v Securities and Exchange Board of India (SEBI), the SAT upheld an order of the SEBI by which independent directors were held liable for their positions and roles on key board committees. The Supreme Court refused to interfere with the SAT’s decision, signalling less judicial tolerance for lapses by such officers.
The SEBI received a complaint that Setubandhan Infrastructure Limited, a company listed on India’s stock exchanges, had, inter alia, misrepresented financial records through fictitious purchases and diversion of funds, and failed to disclose related party transactions. Relying on an independent forensic audit report, the SEBI issued show cause notices to the company’s independent directors, among others, to demonstrate why they should not be liable for such governance failures.
In submissions to the SEBI, the independent directors relied on a well-worn defence that they did not know of nor participated in the day-to-day affairs of the company. They also claimed that they did not attend meetings of the board, the audit committee, or the nomination and remuneration committee, despite being appointed members. One of the independent directors insisted he had accepted the role on the basis of assurances from the promoters that it was a networking opportunity and that his appointment was primarily intended to provide comfort to the company’s lenders.
The SEBI contended that independent directors are bound by schedule IV to the Companies Act, 2013 (act), which sets out their code of conduct. This requires independent directors to actively oversee internal controls and risk management systems. The SEBI also relied on regulation 18 of the SEBI (Listing Obligations and Disclosure Requirements), 2015 (LODR regulations), which mandates that every publicly listed company appoint an audit committee. This committee is tasked with monitoring the company’s financial reporting and proper disclosure of its financial information to ensure public investors are assured of the financial integrity of such material.
The SEBI rejected the independent directors’ contentions, emphasising that both the act and the LODR regulations impose a positive duty on independent directors to detect and prevent financial misconduct. Relying on the Supreme Court’s 1973 decision in Official Liquidator v PA Tendolkar, the SEBI restated that an independent director may be held liable for dereliction of duties and be compelled to make good the losses incurred due to their neglect, even if they took no active part in the commission of the fraud.
Affirming the SEBI’s findings, the SAT pointed out that the company’s annual reports showed that not only had the independent directors attended meetings, but also one was the chairman of the audit committee and the other was a member. By accepting the position of independent directors, the appellants undertook obligations which they had failed to fulfil. This decision is consistent with previous rulings of the SEBI in the matter of Manpasand Beverages Limited, where independent directors were held liable for failure to exercise diligence as members of the audit committee.
The SAT’s decision is a significant departure from the traditional test of liability based on knowledge or day-to-day control. Independent directors are now held to a higher standard. This is more so if they are members of an audit committee because such members are legally obligated to be proactive and diligent, effectively supervising company financial reporting. They must act independently, remain vigilant and not be mere rubber stamps.
This case also shows that financial irregularities are rarely isolated incidents. They are often symptomatic of systemic governance failure. It is not sufficient for independent directors just to turn up and provide veneers of compliance. They must actively perform their duties to prevent and detect such lapses of standards.
Bharucha & Partners – Sneha Jaisingh and Neeraja Barve
