Independent directors: the rules and the real test

Independent directors (IDs) are meant to protect the shareholders who are not in the boardroom: minority investors. They chair the audit committee, approve related-party deals and are supposed to push back on the promoter when needed.

The law sets a detailed test for who counts as independent. But a director can pass every legal test and still be close to the promoter through friendship, past favours or the fees the board pays. A board can meet every rule on paper and still have no real independence.

That is why analysts look beyond the label. The useful questions are about behaviour: how long the directors have served, what else they do for the group, whether they attend meetings, and whether they have ever disagreed with management on the record.

The legal test of independence

Under Section 149(6) of the Companies Act and Regulation 16 of LODR, an independent director must:

• Not be a promoter, or related to a promoter or director of the company or its group
• Not have had a material money relationship with the company, its promoters or group companies in the recent past, apart from sitting fees and commission
• Not have been a key managerial person or employee of the company or its group in the last three years
• Not have been a partner or employee of the company's auditors, or of legal and consulting firms with significant dealings with it, in the last three years
• Not hold, with relatives, 2% or more of the voting power
• Be a person the board considers to have integrity and relevant expertise

Required numbers

• Section 149(4): at least one-third of the board in a listed public company, with fractions rounded up
• LODR Regulation 17: at least one-third if the chair is non-executive; at least half if the chair is executive, or is a promoter or related to one

Other key rules

• Tenure: at most two terms of up to five years each, then a three-year cooling-off period before returning
• Board limits (Reg 17A): independent director on at most seven listed companies, or three if the person is a whole-time director of any listed company
• Appointment and removal (Reg 25): need a special resolution of shareholders, meaning at least 75% of the votes cast
• Databank: IDs must register with the Independent Directors' Databank run by the Indian Institute of Corporate Affairs and, unless exempt, pass an online proficiency test
• Separate meeting: IDs must meet at least once a year without management
• Insurance: the top 1,000 listed companies must buy directors' and officers' insurance for their IDs
• Liability: Section 149(12) limits an ID's liability to acts done with their knowledge or consent, or where they did not act diligently
• Resignation: the company must disclose the ID's detailed reasons for leaving, along with the director's confirmation that there are no other material reasons
• Moving to management: an ID who resigns cannot become a whole-time director of the company or its group for one year

The practical independence test

Use the annual report, the corporate governance report and director profiles to check:

1. Tenure. IDs close to the ten-year limit, or who joined the board decades ago under the promoter's parent, may be too close to management.
2. Past roles. Former employees, auditors, lawyers or consultants of the company or its group, even after the cooling-off period.
3. Other boards. IDs who sit on several boards within the same promoter group.
4. Money. Commission and sitting fees that are large compared with the director's other income, or professional fees paid to firms linked to the director.
5. Attendance. Board and committee attendance below 75%.
6. Committee roles. Whether IDs actually chair the audit and nomination committees.
7. Exits. Several IDs resigning within a short period, especially before results or a major deal.
8. Voting record. Any instance of an ID dissenting on record. A board where every resolution passes without debate for years tells its own story.