Updated July 12, 2023
Introduction to Independent Director
Shareholders invest their money in the business. The business takes a corporate form, and investors cannot look into the organization’s day-to-day activities. Hence, they appoint directors to look after the daily chores of the commercial activities.
However, some directors may take advantage of the power imparted by the board. Directors may enter into some transactions with the related parties of directors and squeeze the company’s reserves.
Who is the Independent Director?
- An independent director is a member of the board of directors of a company who does not participate in the daily chores of the entity’s operations and does not have a material relationship with the company. Thus, he is also referring as the non-executive director of the company.
- The word “independent” attains its importance only when the board of directors confirms that the directors do not have any material relationship with the company. Material relationship refers to a business relationship between a person and a limited benefit company transacting through self, a family member, or an officer wherein the person has some beneficial interest.
- Material relations can be in the form of direct control of the other entity, being a partner or shareholder or an officer of another entity. Related-party transactions are generally allowed but only up to a certain level.
- These provisions apply to the listed entities. In addition, the parent or subsidiary of such a listed company also covers these provisions.
Role of Independent Director
- The independent director plays a passive role in day-to-day activities but plays an active role in the committees set up by the company. In addition, he is responsible for managing the risks and ensuring corporate governance standards within the company.
- He holds a vital role in succession planning for the company.
- He ensures a balance between the conflicting interest of the stakeholders.
- Independent Director is Mentor and guides the company since he possesses expertise in one of the primary business areas.
- He is responsible for being objective while evaluating the performance of the directors.
- Independent Directors are vital in ensuring the integrity of the financial controls and systems.
- He is involved in the key strategy-making process, appointing key persons, designing the standards of conduct, and risk management.
- Should provide levels within which remuneration can pay to the key managerial personnel of the entity and other executive directors.
- He provides solutions in case of conflicts between the management and the interest of the company’s shareholders.
Responsibility of Independent Director
- He Should try to attend the general meeting of the company and meetings of the board of directors.
- He should act within the authority provided to him.
- Attend the committee meetings wherein he is the committee’s chairperson.
- Should have enough knowledge of the company and the environment surrounding the company.
- Independent directors should take care of the interests of the company, its shareholders, and its employees.
- He is responsible for reporting the actual or suspected chances of fraud or any willful violation of the company’s code of ethics.
- He holds critical information such as technologies, promotion plans, price-sensitive knowledge, and business secrets. And should keep the information confidential unless expressly allowed to disseminate by the board or required under the law.
- He should safeguard the interest of the stakeholders, especially the minority ones.
- He should ensure that the vigil mechanism is adequate and functional at all times and the person using the facility is free from any risk due to using such facilities.
Applicability on Appointing Independent Director
- At the time of appointment of an independent director, the board needs to determine whether the person has any material relationship with the company.
- In doing so, the board checks that the person’s relationship falls within the familial, accounting, consulting, commercial, banking, charitable, or legal category.
- If the board successfully determines that no such relationship exists, the person is eligible for appointment as an independent director of the company.
Provisions Related to Independent Director
A person cannot treat as an independent director if he:
- Is an employee, or is an immediate family member of the company’s executive director?
- A partner of an employee of internal or external company auditors, whether present or former auditor.
- Is an immediate family member of the partner or employee of such auditors in clause b.
- Is in receipt of compensation of more than US $ 120,000 per annum for services other than being a director of the listed company. However, such compensation should not be contingent on the continued services and not concern the pension or deferred compensation for prior services.
- Is an immediate family of the person as specified in clause d.
- Is an employee of the company who receives or makes payments to the listed company concerning the property or services for an amount that exceeds 2% of the company’s consolidated gross revenues or the US $ 1 million in any of the preceding three fiscal years.
- An immediate family member of the company’s executive officer as specified in clause f.
- Also, if the person has had such a relationship as above in the last three years, the person would not be qualified as an independent director. Thus, the criteria limit is three years preceding the year of appointment.
- Companies listed on the New York Stock Exchange and Nasdaq must comply with stricter norms about the independence criteria. Such companies should ensure that the director’s ability to remain independent is not affected by any material relationships, including the impact of any compensatory fee paid or being affiliated with the subsidiary or affiliate of a subsidiary of the company.
- If the company imposes additional independence standards, it must disclose the same.
- As per NYSE listing rules, the listed companies in the US should have the majority of directors as independent directors.
Benefits
- The business transactions are fair without the dent of being biased toward directors.
- Stakeholders’ interest is protected.
- Independent directors are free from undue influence from the management.
- The expertise of the independent directors can be used for the company’s benefit.
- The performance evaluation of the directors is objective and without any bias.
- They are essential to good corporate governance policies.
- He helps in the succession planning of the company.
- He resolves the conflicts between the shareholders and the management.
Disadvantages
- The company has information asymmetry since independent directors do not know about the daily chores. Thus, the information received by such a director is some systematic noise.
- An Independent director is still a director, and his decisions are subject to approval from the board members.
- Due to asymmetry in the information exchange, ad hoc invitations to the board meetings do not suffice for the purpose. Thus, a completely independent board would work with poor information, and the objective of independence would be ineffective.
Conclusion
Listed companies are required to ensure compliance with independent directors. However, after observing the disadvantages of independent directors, it is not feasible to appoint 100% independent directors to the company’s board. On the other side, a sufficient number (like fifty percent) is required to ensure good corporate governance and the creation of long-term value for the company.
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