New Remuneration Regime for Independent Directors - Will It help in attracting better talent on the boards of India Inc

Recently, the Ministry of Corporate Affairs (‘MCA’) has notified the amendments made to Sections 149(9) and 197(3) of the Companies Act, 2013 (‘2013 Act’) by the Companies (Amendment) Act, 2020 (‘2020 Amendment’) -to enable companies faced with absence or inadequacy of profits to pay certain minimum guaranteed remuneration to Non-Executive Directors (‘NEDs’) and Independent Directors (‘IDs’), as may be prescribed. On the same day, the MCA also issued a Notification to amend Schedule V of the 2013 Act to prescribe the scale of remuneration which can be paid to NEDs and IDs, depending on the effective capital of the company.

The legal position prior to the 2020 Amendment

Prior to the 2020 Amendment, Section 197(3) read with Schedule V covered only Managing Directors, Whole-time Directors and Managers – as defined in the 2013 Act. NEDs and IDs had been excluded from the ambit of Section 197(3). This meant that when the going was good and the company had made adequate net profits, (calculated as per the methodology prescribed under Section 198 of the Act), companies could pay up to 11 % of the net profits of the company, if there is a managing or whole-time director or manager and 3% of net profits in any other case.

In a situation where a company has not made any profits or made inadequate profits, Managing Directors, Whole-time Directors and managers could be paid sitting fees for attending board meetings in accordance with Section 197(5), and minimum remuneration in accordance with Section 197(3), read with Schedule V.  But, in the same situation, NEDs and IDs could only be paid sitting fees for attending board meetings in accordance with Section 197(5) – and were not entitled to anything else.

This inconsistency in the legal architecture relating to remuneration of NEDs and IDs was highlighted by the Company Law Committee, 2019 (‘CLC 2019’)[1]. In its Report, the CLC 2019 recommended that Sections 149(9) and 197(3) should be suitably amended to cover NEDs and IDs, who should be allowed to receive minimum remuneration fixed by the company in accordance with the amended Schedule V.

The CLC 2019 gave the following reasons in support of the amendment:

  • NEDs and IDs give their valuable time to the company and have the experience to give critical advice to the company. Hence, even in a situation of no profits or inadequate profits, the company should be permitted to grant them remuneration that is at par with the remuneration provided to executive directors.
  • There is a need to develop remuneration policies that would allow the company to attract and retain competent directors.
  • Inconsistency in payment of remuneration in case of losses or inadequacy of profits disincentivises NEDs and IDs from joining the Board.

It is significant to note that Section 149(9) of the 2013 Act has put an absolute embargo on the grant of ESOPs to IDs while casting onerous responsibilities on them. This restriction was introduced by the 2013 Act as it was felt that ESOPs could compromise the ‘independence’ of independent directors. Strangely, NEDs – who have similar roles & responsibilities under the Act as IDs – were not deprived of the benefits of ESOPs.

In a loss-making company, NEDs and IDs obviously cannot receive any commission based on net profit. Further, under Rule 4 of the Companies (Appointment and Remuneration of Managerial Personnel) Rules, 2014, the sitting fees payable to any director for attending a Board or Committee meeting cannot exceed INR 1 Lakh per meeting. This led to a grossly inadequate remuneration framework for IDs in loss-making companies.

The meagre remuneration was not commensurate with the larger role that NEDs and IDs were expected to play in ensuring better corporate governance and the onerous responsibilities that have been statutorily imposed on them – under Section 177 (Audit Committee), Section 178 (Nomination & Remuneration Committee) and Schedule IV (Code for Independent Directors) of the Act. The IDs on the board of listed companies have additional responsibilities under the SEBI (PIT) Regulations, 2015, the SEBI (LODR) Regulations, 2015 and the SEBI (SAST) Regulations, 2011.

The 2020 Amendment and the revised Schedule V

The recommendations of the CLC 2019 were incorporated by the 2020 Amendment – which amended Sections 149(9) and 197(3) to allow a company to grant remuneration to NEDs and IDs in accordance with the Schedule V limits. On March 18, the MCA also issued a notification which amended Schedule V – to prescribe the remuneration limits for NEDs and IDs, in situations of no profits or inadequate profits.

The limits for remuneration payable to NEDs and IDs under Section II of Part II of Schedule V are as follows:

Where the effective capital is (in INR): Limit for yearly remuneration payable to NEDs and IDs in case of losses or inadequate profits (in INR).
Negative or less than 5 crore. 12 Lakh.
5 crore and above but less than 100 crore. 17 Lakh.
100 crore and above but less than 250 crore. 24 Lakh.
250 crore and above. 24 Lakh plus 0.01% of the effective capital in excess of 250 crore.

As minimum remuneration can now be paid to NEDs and IDs irrespective of the net profits, it is expected that there will be fewer instances of the management teams  artificially inflating the net profits of the company by under-provisioning of liabilities. The limits prescribed in Schedule V can be exceeded by the company after obtaining shareholder approval through a special resolution. Hence, irrespective of net profits, companies can now pay any amount of remuneration to NEDs and IDs, after obtaining shareholder approval by special resolution.

The amendment to Schedule V has also liberalised the remuneration norms for NEDs and IDs of companies that have undergone the IBC resolution process. Under the revised Schedule V, a company in relation to which a resolution plan has been approved by the NCLT under the IBC, 2016 can pay any amount of remuneration to its NEDs and IDs – for a period of five years from the date on which the NCLT approves the resolution plan.

The changes made in the Act for the payment of minimum guaranteed remuneration of NEDs and IDs seem to have been unconnected with a new Consultation Paper floated by SEBI on March 1, 2021 – on the issue of ESOPs with a longer vesting period of five years to IDs, in lieu of the current regime of profit-based commission.

“Effective Capital” – Is it the right benchmark for determination of Managerial Remuneration?

The limits prescribed under Schedule V are based on the “effective capital” of the company.

For the purposes of Schedule V, “effective capital” has been defined as the aggregate of the paid-up share capital (excluding share application money or advances against shares) standing to the credit of the share premium account; reserves and surplus (excluding revaluation reserve); long-term loans and deposits repayable after one year (excluding working capital loans, overdrafts, interest due on loans unless funded, bank guarantee, etc), as reduced by the aggregate of any investments, accumulated losses and preliminary expenses not written off.

In case of an investment company whose principal business relates to the acquisition of securities, the investments made should not be deducted while calculating the effective capital.

The rationale behind linking the remuneration limits to the “effective capital” of a company seems to be to ensure that minimum payments to directors are made in accordance with the size and scale of the company’s its operations. Effective capital of a company is not a very good indicator/benchmark for determining the remuneration limits as there could be more complex business challenges in a company with a lower effective capital.

Many complex companies with significant business challenges in the technology space could have a lower effective capital. The MCA needs to link remuneration limits to a combination of factors, and not merely the effective capital employed. 

Clawback of excess remuneration paid under Section 199 – should it be made applicable to NEDs and IDs?

Section 199 of the 2013 Act provides that where a company is required to re-state its financial statements due to fraud or non-compliance with any requirements under the Act, the company shall recover from any past or present managing directors, whole-time directors or manager or Chief Executive Officer (by whatever name called) who have received the remuneration (including stock option) in excess of what would have been payable to him on the revised net profits as per the re-stated financial statement.

Presently, this clawback provision is not applicable to NEDs and IDs.  As NEDs and IDs will now be eligible to receive the guaranteed minimum remuneration irrespective of net profits, there is no reason why they should not be subjected to the same clawback obligation. This would require amendments to Section 199, which Parliament must carry out.

Concluding Thoughts

Unrealistic restrictions on managerial remuneration imposed in the 1970s and 1980s have been progressively liberalised over the years. The Companies (Amendment) Act, 2017 has dispensed with the requirement of prior Govt approval for payment of remuneration beyond the limits specified under Section 197, so long as the shareholders support it by a special resolution, and there are no defaults to banks or public financial institutions or non-convertible debenture holders or other secured creditors, as the case may be.

The 2020 Amendment and the revised Schedule V have further liberalised the regime by allowing NEDs and IDs to draw minimum guaranteed remuneration irrespective of the net profits of companies. This amendment is a step in the right direction. It is expected that this change may lead to more professionals joining the corporate boards. However, such professionals will be willing to join the board provided that such change in the remuneration is also accompanied by suitable changes to the provisions relating to criminal liability of non-executive directors, for violations of law by the companies – which has led to avoidable harassment and mental stress to such directors

[1] Report of the Company Law Committee 2019, 14th November 2019, at Pg. 47 and 48.