The Foibles of a Databank and Proficiency Test for Independent Directors

There is no gainsaying that board independence has come to assume a pivotal position in corporate governance. Although it continues to receive constant criticism on account its ineffectiveness, no one musters the courage to banish it or even diminish its importance. While the concept of independent directors only gradually received the required attention and seriousness in India, it has been the subject matter of stringent regulation under the Companies Act, 2013 and the rules issued thereunder. Despite these developments, independent directors attract reproach on the ground that they are independent in form but not in fact, and that they have failed to act as required in companies where governance has imploded.

Recognizing these concerns, the Ministry of Corporate Affairs (“MCA”) has taken some recent steps, as discussed below, to tighten the screws on independent directors. These measures, which take effect on 1 December 2019, introduce greater stringency in the selection and functioning of independent directors, but they also lead to a great deal of rigidity, thereby leading to unintended consequences that might alter the benefits emanating from board independence.

Databank for Independent Directors

One of the unique features of the Companies Act, 2013 is that it provides for a databank of independent directors in section 150. It allows companies to select independent directors from such a databank, which will contain names, addresses and qualifications of persons who are eligible willing to act as independent directors. Although most of the corporate governance provisions of the Companies Act, 2013 came into effect on 1 April 2014, the databank has not yet become operational. It was only on 22 October 2019 that the MCA issued the Companies (Creation and Maintenance of Databank of Independent Directors) Rules, 2019 (the “Databank Rules”), the substantive portions of which take effect on 1 December 2019. These rules provide that the Indian Institute of Corporate Affairs (“IICA”) would create and maintain a databank of independent directors, and they also prescribe the type of information it would contain. The individuals included in the databank must have passed an online proficiency self-assessment test for independent directors.

On the same day that the MCA issued the Databank Rules, it also issued the Companies (Appointment and Qualification of Directors) Fifth Amendment Rules, 2019 (the “Amendment Rules”), which now stipulate that every individual who is, or desires to be, an independent director must apply for inclusion of their name in the databank for a prescribed period of time, and thereafter ensure that the same is renewed from time to time.

The existence of such a government-controlled database of independent directors is somewhat peculiar to India, as I am not aware of any leading corporate law jurisdiction that prescribes such a requirement. The genesis for a databank effectively emanates from concerns expressed by small and medium enterprises (“SME”) who do not have the wherewithal to identify and appointment the requisite number of independent directors. However, for the vast majority of companies that are required to appointment independent directors, either because they are listed on the stock exchange or due to their large size, it is hardly the case that company managements will scour a databank that is likely to contain thousands of candidates. Given that board members must work closely, the lack of prior knowledge or information regarding the background and capabilities of a candidate would be a disincentive for companies to simply appointment someone from the databank. Granted that the databank seeks to alleviate the concern that companies will likely appoint individuals who are favourable to company managements’ views and are less likely to question corporate decisions, but a databank is unlikely to be the panacea to such ills.

The question of whether every independent director must mandatorily be included in the databank is a thorny one. Section 150 of the Companies Act, 2013 stipulates that “an independent director may be selected from a data bank”. The use of the expression “may” suggests that the databank is rather a facility provided to companies rather than, as Vinita Nair notes, a definitive mandate. By now making the databank mandatory for each independent director, as it is somewhat inextricably linked to the proficiency test requirement, the Amendment Rules run the risk of exceeding the brief set out by the statutory provision.

Online Proficiency Self-Assessment Test

Through the Amendment Rules, which take effect on 1 December 2019, the MCA has introduced a mandatory proficiency test for independent directors. Every individual whose name is included in the databank must pass the online proficiency self-assessment test within a period of one year from the data of inclusion in the databank. Failing this, such person’s name will be removed from the databank.

The test itself will be administered by the IICA, and is meant to cover areas such as company law, securities law, basic accountancy and relates aspects relevant to one’s functioning as an independent director. The pass percentage is fixed at 60% aggregate score, although candidates can take the test as many times as they possibly need to pass. The IICA is also expected to prepare study materials and online lessons for the benefit of the test-takers. However, experienced independent directors are exempted from the requirement of proficiency test. The exemptions apply to individuals who have served for a period of no less than ten years as director or key managerial personnel in a listed public company or, alternatively, in an unlisted company with a paid up capital or rupees ten crores or more.

The MCA’s motivation for a test-based approach is understandable. There have been controversies surrounding companies appointing “convenient” individuals as independent directors, even though they may not possess the requisite expertise and are sometimes merely pawns of the management or promoters. Concerns have also been raised regarding the presence of “celebrity” directors on Indian boards. The proficiency requirement would ensure that all independent directors would be conversant with their roles and responsibilities on corporate boards before they take up such positions. This, one expects, would increase the levels of monitoring and compliance by independent directors.

At the same time, it is reasonable to be skeptical about the utility of proficiency tests to assess the quality of independent directors. First, the ability to act effectively as independent directors arises through considerable experience in the corporate sector, either as directors or key managerial persons. In the absence of such experience, mere proficiency tests would hardly add any value.

Second, the proficiency testing system that MCA has introduced is both narrow and wide. It is narrow because of its focus on matters of company law, securities law, accounting and the like. This make matters rather compliance-focused. Of course, directors must be apprised of their duties and liabilities, but the current approach concentrates excessively on the monitoring and compliance functions of independent directors, who tend to play a much larger role than mere watchdogs. On the other hand, the proficiency test requirements are wide because they adopt a “one size fits all” approach. Presumably, the test would have very little regard, if at all, to the type of company, type of controlling shareholder, nature of business or other specificities involving various boards. In that sense, independence must be tailored to suit individual circumstances. There is no indication thus far that the test would account for the divergence of expectations from board independence. On the contrary, more emphasis could have been placed on training and mentoring of novice independent directors that is conducted by the companies who appointed them. This would provide them with the relevant knowledge, skills and experience rather than a standardized test requirement.

Third, a test requirement mired in bureaucracy may have the effect of eliciting interest from a population that is inappropriate. Although the standards or the levels of difficulty at which with the test will be calibrated, there is reason to believe that they are likely to be more lenient than harsh. This will enable greater numbers of individual to be “proficient” independent directors. On the other hand, the more qualified individuals may be disincentivized from taking up independent directorships if they have to undertake a test, especially if they are less sanguine about its utility. This will result in a scenario where able individuals will not be qualified to take up independent directors. There are already concerns about the dwindling pool of independent directors, as statistics show that a “total of 606 independent directors resigned from the National Stock Exchange-listed company boards in 2018. In comparison, 412 independent directors resigned between January 1 and July 22 this year.”

Fourth, measure such as proficiency certification carry risk, as they carry a false sense of security to shareholders and other beneficiaries of vigilance by independent directors. Capabilities assessed by a proficiency test are not always likely to bear results in real-life situations that independent directors encounter on a daily basis. Nevertheless, when confronted with questions regarding their actions or omissions, independent directors may likely use their proficiency testing as a shield against possible liability. Such a potential safe harbor defence, one that ultimately needs to be tested in the courts, will undermine the entire proficiency testing exercise. On the other hand, it is necessary to develop a regime whereby greater proficiency will enhance the onerous nature of independent director responsibility. Ultimately, proficiency testing is an inappropriate proxy for the knowledge, skills and experience to deal with specific situations as they arise in individual companies. The legal regime in developed markets confers the role of addressing these firm-specific measures to courts, who subject the directors to the test of whether they have discharged the fiduciary duties imposed on them. In India, however, courts have hardly taken on the mantle of defining and enforcing standards of directors’ duties, partly because private enforcement is inapt due to inefficiencies in the court system.

An Inapt Solution

In all, it is hard to argue against a sustained overhaul of the board independence system in India, as it is an important tool for corporate governance. But, measures such as a databank of independent directors and their assessment through an online proficiency self-assessment test are hardly apposite for the situation, as they lead to unintended consequences. Ultimately, the measures must be firm-specific and not bureaucratic interventions of the kind presently attempted.

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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