Dual Approval System: An effective remedy or an unnecessary hurdle?
Devanshi Soni & Sakshi Choudhary†
Securities and Exchange Board of India (“SEBI”) amended its SEBI Listing Obligations and Disclosure Requirements (LODR) on August 3, 2021. This included certain amendments to the provisions related to the appointment and removal of Independent Directors(“IDs”) as an aftermath of SEBI Consultation Paper on Review of Regulatory Provisions related to Independent Directors. In this, the SEBI had suggested the introduction of the ‘Dual Approval System’ and the ‘majority of minority’ voting style for the appointment and removal process to strengthen the framework of IDs. However, the same was not adopted by SEBI and the special majority system is currently in force for appointment and removal of IDs.
IDs are required to keep an eye on financial information to safeguard the interest of minority shareholders but recent events such as the IL&FS Crisis show the ineffectiveness of IDs in detecting corporate fraud and mismanagement. It is a prime example of the failure of independent directors in carrying out their duties.
The reason behind such a lapse is that IDs are not really independent. Promoters have a significant influence on both the appointment and removal process of IDs. A promoter is a person, a firm or an association who decides an idea of setting up of business and carries out all the formalities. While in private companies, promoters tend to appoint a favourable person as an Independent Director; in PSUs, the appointment of independent directors is mostly leaned towards the ruling party. Similarly, they are removed when they do not favour the wishes of the promoters. This was the case with Nusli Wadia. Wadia was removed as an ID from Tata group of companies amid the Tata-Mistry Dispute. Wadia had openly sided with Mistry. Therefore, the influence of promoters may cause a hindrance when the interests of the minority shareholders are not in alignment with that of the promoters.
Independent Directors (IDs)
The concept of IDs was brought in by the recommendations of the Committee on Corporate Governance with Shri Kumar Mangalam Birla as the chairman in 1999. Later it was adopted formally in the Companies Act, 2013. Independent Director works as a balance between the mighty promoters (promoter groups) and the individual or minority shareholders. The Nomination and Remuneration Committee (“NRC”) is a committee constituted in companies to fulfil the criteria mentioned in section 178. The members of the Committee are appointed by the Board of the company and every listed company is required to constitute an NRC. NRC recommends the names of IDs. These recommendations are approved by the Board and then voted and appointed by the shareholders through an ordinary resolution. (Or special resolution in case of re-appointment.) Similarly, IDs can be removed by a simple majority in their first term and by special resolution in the second term.
The amendment in LODR scrapped the simple majority concept. Under the new rules, special resolutions need to be passed for both the appointment and removal of directors to ensure that IDs are not run by the whims of promoters. As per Section 114(2) of the Companies Act, 2013, a special resolution is passed when the votes cast in favour of the resolution is three times the votes cast against it.
The consultation paper suggested a system of ‘Dual Approval’ for the appointment and removal of IDs. To suggest this, SEBI relied on similar practices from Israel and the UK. Dual Approval System requires the fulfilment of two conditions.
1. Approval by a majority of all shareholders.
2. Approval by the ‘majority of minority’, that is the approval of shareholders other than the promoters.
If these two votes contradict each other and the candidate fails to become an ID, he can be renominated after the cooling period of 90 days for approval, by a special resolution of all shareholders.
‘Majority of minority’ (MOM) is a method used in Israel to approve certain transactions of a company including the appointment of an ‘outside’ director. It ensures that the promoters do not usurp their powers and use them to control the IDs. Similarly, the UK has adopted a dual-voting structure for the appointment of independent directors in controlled listed companies.
However, the important thing to note here is that the concept of ‘Majority of minority’ is not unfamiliar to India. SEBI mandates the ‘majority of minority’ in certain business transactions such as Related Party Transactions (Reg 23 of SEBI LODR) and Section 188 of Companies Act, a merger of an unlisted company which results in a reduction of pre-merger public shareholding by 5% and delisting of the company.
The question that remains is if the ‘majority of minority’ concept is so beneficial to strengthen the framework of the independent directors, then why is it that the market regulator did not adopt it in the process of appointment of ID?
The answer is that primarily the voting structure is not feasible for the reason that it defeats the concept of corporate democracy.
Firstly, putting the individual or minority shareholders who do not have substantial interest compared to the promoter group on the same pedestal can be dangerous for the operations of the company. The business strategies of the company are decided by the promoters/controlling shareholders. Promoters are more equipped to determine the right candidate for the position of IDs. They have the resources to gather information on the candidates such as data regarding their past performance on other boards, their understanding of the business of the company, etc. Minority shareholders, on the other hand, do not have the collectiveness to ensure all of these factors and arrive at a decision. Dispersed minority shareholders might be apathetic and thus not arrive at a conclusive and final decision. Such a scenario can in turn cause loss of the company’s resources and time.
The ideal compromise in this situation is to accord Veto Power to minority shareholders. This can be exercised by the approval of 1/3rd of minority shareholders. Veto Power in the hand of minority shareholders should be implemented in the process of re-appointment and termination. Veto power at the stage of re-nomination will ensure that an ID favouring the promoter does not get re-elected. Equally, veto power at the stage of termination will ensure that promoters do not remove an ID who can go against them. This provides ideal balance between the arguments that Promoters are the best judge for their business and the interest of minority shareholders should be protected. Dual- Approval system on the other hand introduces MOM at the stage of initial appointment. In case of any disagreement between the minority and majority of shareholders, the election process will result in a nullity. Therefore, the appointment of ID should have only a special resolution method and the re-appointment and termination stage should have veto power in the hands of minority shareholders to safeguard the interest of minority shareholders and ensure timely appointment of IDs. This can prove to be the best middle ground for the prevailing situation.
Secondly, the process of voting becomes expensive, uncertain and long. In the case of a Dual approval system, both the conditions need to be satisfied for appointing or removing the director. In a case where minority shareholders do not agree with the consensus of all shareholders, the candidate will not succeed. This process gives an unfair advantage to minority or individual shareholders. After the candidate has failed in the dual approval system, he can again be nominated after the cooling period of 90 days and put to vote for a special resolution and thus rendering the whole process useless. Contradiction in minority and promoter groups ends up costing huge sums of money to the company. Hence, having veto power in only re-appointment and termination but not in initial appointment could safeguard the rights of the minority shareholders and save company’s resources.
Thirdly, even though minority shareholders will be given an equal footing with the promoters, it will not serve the purpose. In majority of the companies in India, the minority shareholders are the institutional investors be it foreign or national. Therefore, the market regulator has accurately omitted the ‘Dual Approval’ system in the recent amendment. Apart from the Dual approval system, many other ideas to strengthen the Independent Director System have been suggested and introduced. One such initiative is the creation of a database for IDs.
IDs are crucial players in every company’s board. Strengthening the framework of IDs will benefit the minority or individual shareholders. However, the Dual Approval system for appointment and removal of IDs is rightly omitted by SEBI in its amendment to LODR. It will create an unnecessary hurdle for the companies, rather than helping them. Amending the criteria to pass a Special Resolution instead of an ordinary Resolution suffices the purpose of keeping the interest of minority shareholders intact. There are various methods such as Veto Power to minority shareholders, which can be implemented to ensure that the interest of minority shareholders is safeguarded. SEBI and MCA can collectively make efforts to achieve the goal of creating a data bank and ensure that only qualified and ethical individuals become IDs.
†Devanshi Soni and Sakshi Choudhary are 3rd year B. COM, LL.B. (Hons.) students at Gujarat National Law University.