Independent Directors Part II

Part II to my earlier post on Independent Directors (available here )

It is well established in the international scenario that with regards to liability, there is no difference between an executive and non-executive director, the cases of Dorchester Finance v. Stebbing[1] and New Jersey Supreme Court in Francis v. United Jersey Bank[2]  illustrate the same. A director has a fiduciary relationship with his company and thus has a duty to avert conflict of interest with the company as a whole.

The Business Judgment Rule is an American case law originating concept in corporate law whereby the “directors of a corporation . . . are clothed with [the] presumption, which the law accords to them, of being [motivated] in their conduct by a bona fide regard for the interests of the corporation whose affairs the stockholders have committed to their charge”[3] To dispute the actions of a corporation’s board of directors, a plaintiff assumes “the burden of providing evidence that directors, in reaching their challenged decision, breached any one of the triads of their fiduciary duty—good faith, loyalty, or due care”[4]

Section 301 of the Sarbanes Oxley Act requires that each public company have an audit committee comprised exclusively of independent directors.  In order to be independent for these purposes, a director may not (other than in his or her capacity as a director) accept any consulting, advisory, or other compensatory fee from the company, or be an “affiliated person” of the company or any of its subsidiaries[5]. The New York Stock Exchange regulations also stress the value of independent directors. The NYSE requires that a majority of the board of directors of a listed company be “independent,” unless the company is a “controlled company,”[6] a limited partnership, is in bankruptcy proceedings or lists only preferred or debt securities.[7] It was found in a U.S. study[8] that there was no relation between board composition and performance, however, companies with independent boards showed more CEO sensitivity to performance.

The cases of Worldcom[9], Enron[10] and Walt Disney[11] involved the issue of liability of independent directors.The collapse of both WorldCom and Enron was the result in both cases of management’s falsification of the company’s financial statements, and in both cases it was determined by the court that the directors had not participated in the misrepresentations involved; they had simply failed to detect it.

As directors have the burden of proving their own due diligence in securities class actions, even in cases of fraud by management, the risk that they will be held liable is higher than in ordinary cases of director malfeasance, where directors are held only to a duty of care. The conclusion arrived at in the Walt Disney case was that it is inevitable that the liability arises on account of conduct , act or omission on the part of a person and not merely on account of holding an office or a position in a company.

Section 5 of the Companies Act provides the meaning of ‘officer in default’ and clause (g) of the section specifies that if no directors are specified as ‘officer in default’, all directors including independent directors come under this category. From this it can be inferred that an independent director can be liable for the acts of the company or any of any specific officers.  The Indian position on liability of independent directors is an ambiguous one. Diligence of the director and knowledge and actual involvement in the breach or default in question of the director are points of key importance.

The Supreme Court ruled in the SMS Pharmaceuticals case[12] that “the liability arises on account of conduct, act or omission on the part of a person and not merely on account of holding an office or a position in a company”. The Naresh Chandra Committee report suggests that independent directors should also be held liable for acts or omission albeit relating to the areas where they are in charge. Questions to be taken into account to determine their liability include: Whether they have taken at least a reasonable effort to discharge their duties or have they been totally negligent, whether they have attended certain minimum board meetings, and whether they have discharged their duties as members or chairman of audit committee.[13]

Although the proposed Companies Bill, 2009 provides a definition of independent directors, mere recognition would not answer the question of their liability.

The IFCI and the IDBI have intricate instructions for their nominees on company boards and provide an element of protection to their nominee directors against legal prosecution or other proceedings under specified circumstances. Such protection is not available to non-executive independent directors.

T.C.A. Ramanujam,  former Chief Commissioner of Income Tax is of the opinion that as long as independent directors show due diligence, the law should exempt them from all types of liabilities for the actions of the board or the managing director they may not be aware of.[14]

It thus appears that the liability of independent directors depends upon the direct involvement of such director in any fraud and whether or not due diligence was taken

[1] [1989] BCLC 498.

[2] 432 A.2d 814 at 822 (N.J. 1981).

[3] Gimbel v. Signal Cos., 316 A.2d 599, 608 (Del. Ch. 1974).

[4] Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 361 (Del. 1993).

[5] Affiliated person” is defined by reference to the Investment Company Act of 1940 (15 U.S.C. 80-2(a)(3)), and includes any officer or employee of the company or its subsidiaries and any other person that owns five percent or more of the voting securities of the company or any of its subsidiaries.

[6] A controlled company is a company in which more than 50 percent of the voting power is held by an individual, group or another company.

[7] NYSE Listing Standards.

[8] Hermalin and Weisbach, 2001.

[10] Arthur Andersen LLP v. United States, 544U.S. 696 (2005)

[11] Memorandum Opinion, Case No. 15452, May 28,2003.

[12] S.M.S. Pharmaceuticals v. Neeta Bhalla, Appeal (crl.) 664 of 2002.

[13] Pawan Agarwala “Can Independent Non-Executive Directors Become The Directing Mind And Will Of Corporation?” available at (last accessed on 4 October, 2011.)

[14] The Hindu business line internet edition, “Independent directors and vicarious liability” Thursday October 13, 2005