V V Ranganathan: Independent directors: 10 rules

India is increasingly becoming the preferred destination for funds that seek better returns in a fast-growing economy. These funds have championed rigorous governance norms in their home countries and, as they enter the Indian market, they are not going to be kind to Indian company boards. The rules in India on corporate governance have been largely influenced by the Sarbanes-Oxley Act in the US. Sebi revised Clause 49 of the Listing Agreement to amplify its scope and usher in a new era of governance. The changes deal with board composition; independent directors' compensation and disclosures; code of conduct for board members and senior management; audit committees; compliance certificates; and a host of other matters.

The new Clause 49 requires listed companies to have a minimum number of independent directors, which is 50 per cent of the board strength if the chairman is an executive director; if he is not, the board is expected to have at least one-third of its members as independent directors.

Who is an independent director? Clause 49 says you are not independent if you are related to the promoters or persons occupying management positions. There is an embargo of three years for executives and partners of legal, statutory audit, internal audit, and consulting firms associated with the company. There are other restrictions too.

The result of these stipulations is that there is now a scramble for independent directors. While some companies have been proactively dealing with this requirement, many are yet to fulfil their obligations under Clause 49. There is even a website that provides résumés of potentially eligible candidates for companies to choose. If you have posted your résumé on the website, you may well get a call to join a board as an independent director. If so, read on. (And if you are already a veteran director, you may want to take stock of matters and determine if you need to re-jig your approach. The landscape has surely changed.)

I am anxious that I do not scare away directorial virgins. Yet, I am eager to provide them some risk management tips. This article, first in a series on the subject, will give you an overview of the 10 Commandments of risk management for independent directors.

I am told by my lawyer friends that there are over 100 pieces of active legislation in this country, and any morning you may wake up as a criminal because you do not know which law you may have violated. This is a very real problem for independent directors. About a month ago, someone whom I know was issued an arrest warrant for an alleged violation under the Weights & Measures Act. What had he done? He had been a director of a company and had in fact resigned from that board a decade or so ago. Recently, an inspector acting under the Weights & Measures Act alleged that the company had violated some rule, and notices were sent to this person to his erstwhile residential address. These returned un-served and the inspector moved court. This former director had to travel a long distance and appear in the local court in order to get bail. This incident shook him, because there are onerous compliance requirements under several laws: the Factories Act, Shops and Establishment Act, Minimum Wages Act, Essential Commodities Act, Water (Prevention and Control of Pollution) Act, and a host of others. If the director is able to prove that the offence was committed without his knowledge or that he exercised due diligence to prevent the commission of the offence, it is likely that the courts will consider his plea. But the director is expected to be vigilant at all times and demonstrate that he had performed his duties carefully. The claim that one is an independent director and therefore not directly liable under the various statutes could be examined by the court, depending on the facts and circumstances of each case.

It may be a matter of comfort to directors that the conviction levels in India are poor, compared to (say) the US. But the implications of Clause 49 for the board of directors are diverse and explicit, and directors have personal accountability for violations of the law. General insurance companies now offer directors & officers (D&O) liability covers for what they believe are the increasing risks faced by independent directors on Indian boards. The US Securities and Exchange Commission (SEC) website has some revealing statistics. They provide links to litigation releases pertaining to civil law suits filed by the SEC in federal court. During 2002, the SEC filed as many as 619 cases. In 2003 the number was 616, in 2004 it dropped to 490 and it touched 496 in 2005. This is more than one conviction per day! This is not counting the hundreds of notices and orders concerning the institution and/or settlement of administrative proceedings initiated by the SEC. All these relate to various kinds of violations, including those perpetrated by corporate officers and directors.

Given this backdrop, the offer of a board position has to be weighed very carefully. It should never be accepted in a moment of exuberance, for it is not very different from taking a seat in the cockpit of an airplane. The minimum that is expected of you is to be trained as a pilot and have the requisite flying hours to handle different weather conditions and aircraft. The point is that, as a member of the board, you are assuming risks. You alone can determine whether you are up to it or not. The name of the game is to avoid needlessly risky offers, knowing the inherent risks, and developing plans to manage those risks.

Here are the 10 Commandments of risk management for directors (mitigation strategies will follow later in the series).

1. Question whether it is a company that you really want to work with; 2. Question whether you have the equipment and knowledge to meet the expectations of the company and its regulators, without assuming disproportionate risks; 3. Demonstrate that you are independent, as stipulated by law; 4 Enquire whether the company has developed formal control and oversight procedures, and determine whether you can rely on them; 5. Resist unreasonable pressures and maintain objectivity; 6. Keep yourself up-to-date on the subject matters where you are expected to contribute to board deliberations; 7. Obtain copies of the Code of Conduct and ensure that you can abide by it; 8. If you are in doubt, always seek professional help from experts; 9. Always demand all board-related papers well in advance, to prepare for board meetings; 10. Keep all company-related information strictly confidential.