Actions Against Independent Directors

The order was passed on the ground that these independent directors of PSTL failed to perform their role in preventing false and misleading disclosures made by the company in its accounts, which were found to contain inflated profits and revenues through fictitious entries. SEBI refused to accept the independent directors’ arguments that they were not responsible for day-to-day affairs of the company and that they participated at board meetings where only broad policy matters were discussed.

In its order, SEBI has made strong observations regarding the role of independent directors on listed companies:

5. A company acts through its board of directors. It is the duty and responsibility of the directors to ensure that proper systems and controls are in place for financial reporting and to monitor the efficacy of such systems and controls. While the extent of responsibility of an independent director may differ from that of an executive director, an independent director has the duty of care. This duty calls for exercise of independent judgment with reasonable care, diligence and skill which should be reasonably exercised by a prudent person with the knowledge, skill and experience which may reasonably be expected of a director in his position and any additional knowledge, skill and experience which he has. The audit committee exercises oversight of the company’s financial reporting process and the disclosure of its financial information to ensure that the financial statement is correct, sufficient and credible. It reviews the adequacy of internal control system and management discussion and analysis of financial condition and result of operations. The institutions of independent directors and audit committee have been established to promote corporate governance and enhance the protection of interests of investors. These have a critical role to play in the regulation and development of the securities markets and protection of interests of investors in securities.

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7. I find that the noticees overlooked numerous red flags in the trend in revenues, profits, receivables, advances, etc. which could not escape the attention of an independent director, who is also a member of the audit committee. … Such aberrations in financial figures would alert any person of ordinary prudence. The appropriate questions at the right time from the noticees would have unraveled the fraud being played by the company on the innocent investors. By failing to ask the right questions at the right point of time, I find that the noticees have failed in their duty of care as an independent director. They failed to review, as members of the audit committee, the internal control systems, which generated misleading financial statements. I find that the noticees were either too negligent to notice the aberrations in performance of the company and the fraud behind such abberrations or acted as shadow directors of the board / members of the audit committee. In either case, they facilitated the company to make false and misleading disclosures and thereby created artificial prices and volumes in the securities of PSTL in the market, to the detriment of innocent investors. I, therefore, conclude that the charge of disclosure of false and misleading statements, as alleged in the [show cause notice] against the noticees, is established. …

8. Such conduct on the part of the noticees is disgrace to the institutions of independent directors and the audit committee of a listed company. This cannot be viewed lightly and warrants regulatory intervention.

SEBI’s warning signals to independent directors are loud and clear. While this enunciates the importance of the monitoring role of independent directors, it remains to be seen whether SEBI’s order operates as a serious disincentive to otherwise competent and capable individuals from taking up or continuing with their board positions. As we have seen in the past, the Satyam episode resulted in a several hundred independent directors relinquishing their positions from boards of Indian listed companies.

The approach recently adopted by a court in Singapore is even severe. An independent director was sentenced to a four months’ jail term for a misleading statement made by the company to the Singapore stock exchange SGX. A Straits Times news report states:

SINGAPORE’S corporate scene has been stunned by a jail term given to an independent director under stock trading and disclosure laws.

Lawyer Peter Madhavan, a former independent director at scandal-hit air cargo firm Airocean, was sentenced to four months’ jail for his part in making a misleading statement to the Singapore Exchange. He was also fined $120,000.

This is believed to be the first time an independent director here has been sentenced to jail for breaking securities laws. Independent directors are non-executives not involved in day-to-day management.

District Judge Liew Thiam Leng said Madhavan had played a major part in issuing a statement to the SGX in 2005 that tried to downplay a bribery probe involving the firm’s former chief.

He said that as a lawyer, Madhavan was regarded by fellow directors as being more familiar with legal proceedings.

Although Madhavan had no shares in Airocean, he was the ‘most active’ in making the misleading statement, the judge found. He drafted the document and was the ‘main contact person’ with Airocean’s lawyers who amended it.