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Recent Sebi circular on board of directors needs some clarification
June, 10th 2008

Mandatory disclosure requirements with respect to relationships between directors inter se have also been introduced through these recent amendments

The Securities and Exchange Board of India (Sebi) on 8 April issued a circular by which the regulator stipulated certain amendments to clause 49 of the listing agreement. Sebi has sought to further tighten corporate governance norms relating to the composition of the board of directors of a public listed company.

Clause 49 of the listing agreement applies to Indian listed companies. Where the chairman of the board of directors of a listed company is a non-executive director, at least one-third of the board should comprise independent directors, and where the chairman is an executive director, at least half the board should comprise independent directors.

With the recent amendment, a further provision has been made, that is, if the chairman of the board is a promoter or is related to promoters occupying management positions at the board level or at one level below the board, then at least half the board of the company should consist of independent directors.

Persons occupying management positions at the board level or at one level below would include persons who are: (i) directors on the board who also have an executive responsibility (for example, the chief financial officer, where appointed to the board) and (ii) persons who are part of the senior management. Senior management has been defined to mean personnel of the company who are members of its core management team, excluding the board of directors. Normally, this would comprise all members of management one level below the executive directors, including all functional heads.

Mandatory disclosure requirements with respect to relationships between directors inter se have also been introduced through these recent amendments. Such disclosures have to be made in the annual report of the company, in the notice of appointment of a director, in the prospectus and letters of offer for any issuance of securities and in any related filings made to the stock exchanges.

Independent directors are defined in the listing agreement to primarily mean directors who do not have any material pecuniary relationship with the company, its promoters or management, and who are not related to the promoters or members of themanagement.

Clause 49, and the requirement of a minimum number of independent directors on the board, was introduced to improve transparency in governance and to strike a balance between the interests of the promoters and interests of public shareholders.

The rationale for the amendments seems clear. The requirement of at least half the board comprising independent directors does not apply if the chairman of the board is a non-executive director. This is because non-executive directors do not have involvement in, or control over, the day-to-day management of the company, and the role of such directors is usually limited to establishing a strategic vision and providing strategic direction to the company. Technically, this may sound logical, but the objectives can be clearly defeated if the chairman as non-executive director is a promoter or is related to the promoters.

This is quite relevant in the Indian context since even listed companies in India often tend to be predominantly family controlled. There are several examples of promoters or their relatives chairing the board of Indian listed companies and structuring the board composition in a way that ensures non-applicability of the one-half independent rule. This has been done on the basis that the board chairman is a non-executive director.

The issue that arises for consideration is who would be treated as related to the promoters. This is easier answered when dealing with a promoter that is a person rather than a company.

If the promoter is an individual, the persons related to such promoter would include persons who are related by family relationships as defined in section 2(41) and section 6 read with Schedule IA of the Companies Act, 1956.

What happens where the promoter is a company? The listing agreement does not specifically provide any clarification on which persons are treated as related to a promoter that is a company. Possibly, if one of the directors who is connected to the promoterthat is, if he is an employee or director of the promoter or has some other relationship (in the same manner as one would determine whether he is independent or not)is appointed to the position of non-executive chairman, the intention may be to treat such a director as being related to the promoter, and the higher threshold of independent directors would be made applicable.

Having said that, the wording in the circular is not free from doubt and leaves scope for some ambiguity.

The circular directs stock exchanges to amend the listing agreement to give effect to the circular and to indicate implementation status in the monthly report required to be filed with Sebi. However, the circular does not specify a time period within which companies are required to comply with the requirements under the circular. As of 19 May, the Bombay Stock Exchange has amended its listing agreement, while the National Stock Exchange has not taken any steps in this regard.

The circular provides for a gap of 180 days between the resignation or removal of an independent director and the filling up of the vacancy so created by another independent director. During this period, the strength of independent directors on the board of a company could technically fall below the prescribed minimum without attracting adverse consequences.

In many cases the change in the strength of independent directors from one-third to half may require significant reshuffling, depending on the existing composition of the board. In addition to appointing additional independent directors, executive directors may need to vacate their positions to bring the composition of the board in line with the prescribed requirements. The ambiguity arising in relation to situations regarding the promoter in a company may need to be clarified by Sebi to enable companies take necessary action in compliance with the circular.

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