July 2006
LEGAL SIDE

A company is a person in the eye of law but without brain and hands of its own. Directors are the brain and hands of the company. The efficiency, integrity and loyalty of directors have direct bearing with the performance of the company. In an endeavour to improve the corporate performance and to improve the value of all stakeholders, the rules of good corporate governance has emphatically called for the appointment of 'outside' or 'independent director'. In line with the international development on corporate law reforms, the Companies Ordinance, 2062 (the New Company Law) for the first time in Nepal , has made the appointment of an independent director mandatory in all kinds of public companies. But the credit of introducing the concept of independent director goes to the Bank and Financial Institution Ordinance (the BFI Ordinance), 2060. It requires the appointment of at least one independent or expert (Bishesagya) director in every bank and financial institution. But the genesis of idea of an independent director was enshrined long before in the Commercial Bank Act, 2031. Therefore, the realisation of the need of independent director in the good corporate governance is not new in Nepal . The need was reflected in Section 5 (4) of the Commercial Bank Act. Under that section, the government had the power to nominate two directors. The government could also delegate such power to the Nepal Rastra Bank (NRB). But the provision could not operate effectively as the government became fond of making political appointment and NRB started appointing its employee in such post. Virtually, such directors remained independent only by post and not by performance. In light of the bitter practical experience in the banking sector, both the BFI Ordinance and New Company Law have entrusted the company itself to appoint suitable person as an independent director.

This short paper intends to put light on the criteria of independence of an independent director, their role in enhancing good corporate governance and discuss relevant provisions of the New Company Law.

Why to have Independent Director?

A fundamental question is why to bring a stranger in the company as a director. Does not the compulsion of appointment of independent director go against the principle of self-governance and the freedom to run a business? Will he work for the good of the company? These are the questions one often confronts while considering the rationality behind the appointment of an independent director and the ready-made arguments posed by those who oppose the idea of having an independent director.

Company law devises differing level of governance safeguards on the basis of nature, size and ownership structure of companies. Since public companies involve (or may involve) public money, stricter governance regime is indispensable to ensure corporate governance. That is why company law of all jurisdictions have exempted private companies from the obligation to appoint independent director. Only the public companies are required to appoint such a director. Obligation to appoint independent director even in closely held public companies can be justified on the ground that at any time they may invite public to invest money in it. The benefit of limited liability and privilege of raising capital from the public necessarily follows some additional burdens to public companies and this is not against the right of running the business by the company as per its own will. Following points provides justification for the appointment of independent director:

Element of objectivity and expertise in the board

The underlying rationality behind the appointment of an independent director is that his presence in the board is expected to bring an element of objectivity in policy matters. As disinterested parties, they can firmly be expected to bring to the company specific expertise, objectivity and the ability to monitor and assess the board's performance at the highest level without fear or favour. Fundamentally, independent directors do not hold any office in the company and have no management responsibility. Like other non-executive director, they do not involve in the company's day-to-day operation and are not employees of the company. An independent director brings plurality in the composition of board and consequently may bring new vision and prospect in corporate matters of company. They can be a 'custodian' of good governance process.

Effectiveness of various board committees

Similarly, independent directors have an effective role to play in various committees required to be formed by the company under the statute such as audit committee (under Section 164 of the New Company Law), stockholder's relationship committee, remuneration committee. The independence of such a committee, by and large, depends upon the independence of independent or non-executive director.

Check against the abuse of corporate power and protection of minority shareholders

Independent director can play an affirmative role of a 'whistle-blower'. They can act as a check against the abuse of corporate power by the director and conflict of interest that may prevail in the Board. His presence in the board may also be useful in preventing concentration of corporate power and information on one or two directors. They may also be instrumental in protecting the interests of minority shareholders. Other directors may be influenced by the majority, dictated by their own interest while independent director may be a medium of expression of minority shareholders' voice.

Though at surface, the compulsion to appoint independent director seems to be the violation of right to run a business as per own will, the overall objective is to enhance corporate performance by making public companies more transparent and responsible towards its investors.

To conclude in the words of Dr. J.J. Irani Committee (committee formed in India to advise the government on the new company law) "Given the responsibility of the board to balance various interests, the presence of independent directors on the Board of a company would improve the corporate governance. This is particularly important for public companies or companies with a significant public interest."

What are the criteria of independence?

The quest of independence is really rising but the problem is what are the measuring rods of independence. Not to be understood negatively, the idea of a director's independence is equally demanding for all directors. For example, a person cannot be appointed director of the company if he has any personal interest in the business of the company. In the words of Sir Adrian Cadbury, Chairman of the Cadbury Committee in the UK (1998): "The presence of independent members of boards does not imply that they inherently have higher standards of morality than their executive colleagues. It is simply that it is easier for them to take an objective view of whatever matters are under review."

The question of independence in respect of independent director is proximately linked with the idea of objectivity. Independence must be real and true. The independence is not to be understood as a subjective criterion but must be established with full objectivity and in entirety. Not only the proximate but also the remote factors potential to bring fear or favour while discharging their duty must count in judging independence. Family relation, pecuniary interest or any other factors potential to jeopardise the independence should be duly taken into account while establishing the criteria for independence. So, in the quest of true and real independence, the criteria for independence have much more added and elaborated.

Some of the principal criteria of independence have been incorporated in the New Company Law. These criteria are more or less similar to the criteria presented the New Combined Code 2003 of the UK and Recommendations of Dr. J.J. Irani Committee. Some of the criteria are:

l He or his close relatives or firms/companies controlled by him should not have any material pecuniary interest with the company.

l He or his close relatives or firms/companies controlled by him should not have any material pecuniary interest related with the promoter of the company, its directors, top level management or its holding company, its subsidiaries and associate companies.

l He should not hold any cross-directorship or have significant links with other directors through involvement in other companies or bodies.

l He should not have any close family ties with any of the company's advisors, promoters, directors or senior employees.

l He should not represent any significant (substantial) shareholder.

l He should not be involved in the statutory audit firm or the internal audit firms that is associated with the company, its holding and subsidiary companies.

l The legal firms and consulting firms that have a material association with the company, its holding and subsidiary companies.

l He and all his relatives should be a potential supplier, service provider or customer or a lessor or lessee of the company, which may affect independence of the director.

l He and all his relatives should not be substantial shareholder of the company.

The given criteria are non-exhaustive in nature. In the light of experiences gained in the practice, such lists may further go longer.

Criteria of Independence and qualification under the New Company Law

Most of the criteria listed above have been included under the New Company Law under Section 89. According to the said section, the person who cannot be appointed as a director is also ineligible for the appointment as an independent director. In addition to this, a shareholder no matter how many shares he holds in the company cannot be an independent director. Similarly retired officials, auditor and employees of the company are disqualified for the appointment if three years of termination have not elapsed. Close relative of the officials and partner of auditor of the company are not qualified for the appointment.

The New Company Law equally pays regard to the expertise and experience that an independent director should possess. One must possess a bachelor’s degree in the related discipline of transaction of the company or other disciplines such as economics, finance, management, account, statistics, trade administration or law plus working experience of at least ten years in the related field or company management to be appointed as an independent director. Therefore, the New Company Law requires a person as an independent director who is really capable of enhancing the corporate performance by making quality decisions. Section 13 of the BFI Ordinance sets the qualification of an independent director for bank and financial institution.

Number of Independent Director

The number of independent director matters much in what they are expected to serve in the company. While fixing the number, the law should pay enough care. On the one hand, it should not over-burden the company and on the other hand, the presence of the independent director should be substantial to influence the board decisions.

While fixing the number of independent directors, the nature and size of the company must be taken into account. The uniform number of board of director does not suit all the companies. So, the companies, which involve significant public interest such as bank and financial institution, listed companies and other public companies should have a considerable number of independent directors. A company is required to constitute a committee of various types such as remuneration, nomination and audit committees. For the effectiveness of such a committee, the number of directors should be enough.

The New company Law under Section 86 (3) prescribes a minimum of one independent director in each board comprising up to seven directors whereas a minimum of two having over seven directors. This provision has raised a question whether banking and financial institution should have only one director even if they have over seven directors, for Section 12 (1) of the BFI Ordinance requires appointing only one independent director regardless of total number of directors in the board. Some argue that the BFI Ordinance being a special law for banking and financial institutions, the Ordinance prevails over the New Company Law. But this argument is irrational viewed from the overall spirit and perspective of the New Company Law and BFI Ordinance. Bank and financial institutions involve significant interest of public as compared to other general public company. It is the reality that almost about 98 per cent of the money available to a bank for investment comes from the general public. So, greater the involvement of the public fund in the bank and financial institution, greater should be the number of independent directors. So, it is to be understood that only a minimum number of independent director has been prescribed by the BFI Ordinance. If the board has more than seven directors, the Bank and Financial Institution should appoint two directors in accordance with the provisions of the New Company Law.

The New Company Law under Section 164 requires every listed company having 30 million or more as paid up capital to form an Audit Committee comprising at least three directors. But it does not make the presence of independent director mandatory in such a committee. Similarly, the Directives relating to the Corporate Governance issued by NRB requires the formation of an audit committee comprising non-executive directors. The Directives does not set the minimum number of directors in the committee. So, The New Company Law should make a mandatory provision of appointing an independent director, at least one in the audit committee.

Mode of Appointment of Independent Director

The mode of appointment of independent director affects much the element of true and real independence of director. It is the human tendency to be thankful to the appointing person or authority. So, the real risk prevails if the right to appoint independent director is entrusted to a board or the managing director or the chief executive officer. According to Section 87 of the New Company Law, the power to appoint independent director vests with the general meeting. But the BFI Ordinance is defective in this respect. Section 17 (3) of the BFI Ordinance grants the board power to appoint independent director and this provision has frustrated the whole purpose of appointing an independent director. A director appointed by a board cannot be expected to be a watchdog against the abuse of power. He cannot also help The regulator including NRB in true sense.

The BFI Ordinance requires Nepal Rastra Bank to maintain a list of the persons qualified to be appointed as independent director. It is suggested that in case of non-banking companies as well, the list of preparing the qualified person should be entrusted to the Office of the Company Registrar. But experiences of preparing such lists have not been good. Complaints are often heard that all the persons listed by the NRB are not independent. It would be difficult to prepare a list of qualified independent directors as there are numbers of public non-banking companies. The liberty of selecting qualified independent director should be granted to the company. The board should propose the name of the candidates (at least thrice in number) eligible to be appointed as an independent director before the general meeting.

Liability of Independent Director

Independent directors may be at great risk of penalty. Since they are not involved in the day-to-day operation of the company, they have relative shortage of information of the company affairs. But fundamentally, the board's responsibility is of a collective nature. The same statutory obligations and liabilities apply to the independent director. For example in the event of failure to comply with the filing of annual returns required to be filed under Section 81 of The New Company Law, independent director is subjected to same penalty. Therefore, it does not make any difference between the liabilities of independent director and other directors. So, the director should work in a more responsible manner and should be more careful.

Conclusion

The New Company Law has made a good start. The effectiveness of the provision on independent director is yet to be seen in the days to come. The days will show whether, an independent director would be able to institutionalise and enhance corporate governance culture in Nepal .

There are challenges ahead. It is necessary to educate company, board members and chief executive officers and other professionals qualified to be appointed as an independent director. Qualified professionals need to be trained and empowered. There is also a practical problem of remuneration. Since independent director is equally liable as other directors, there would be a disincentive if only sitting fee is offered to them. The service fee offered to them should be adequate to discharge their duty in a responsible manner.

The number of independent directors in banking and financial institution and other non-banking public companies should be made uniform. For this the BFI Ordinance should be amended in line with the New Company Law. Similarly, it would be better to have an independent director in the audit committee. The BFI Ordinance should be amended so as to grant the power to appoint independent director to the general meeting and not to the board of directors.

The practice of preparing a list of independent directors should be discouraged. The company should be allowed to pick a person qualified as an independent director. The board of director of each public company should be entrusted with the task of preparing the list from which the general meeting may chooses the right person for the company.

The New Company Law does not prescribe any specific penalty to a company not appointing independent director. In the absence of such a provision, the general arrangement under Section 162 seems to be applicable which prescribes a fine of Rs. 20,000 in maximum. It is better to have a specific provision on penalty in this regard.

The Office of the Company Registrar should formulate the necessary directives containing the information on important issues such as the qualification and the experience of an independent director, procedure of appointing them in the company, their role, responsibilities and liability and addressing the practical problems.

(Upreti is an Advocate and is presently involved in corporate law awareness building programme launched by FNCCI-CFG Project supported by Asian Development Bank. Narayan Chaulagain helped in preparing this article.)

Against Natural Justice

By Subash Khandelwal

IRD is not following the principles of natural justice while issuing notices in newspapers on the names of those who it claims to be non-filers and defaulters on tax returns, argues this Chartered Accountant based at Birgunj.

A nationwide list of non- filers of VAT returns and defaulters in tax payments is being published by the Inland Revenue Department (IRD). Recently, the Finance Ordinance 2062 (Magh), has added a new provision that any registrant failing to file the VAT return for over 6 months will be blacklisted by the IRD. For such non-filers the carry forward Input Tax Credit, if any, will be made zero and any person/firm or entity doing any transaction will not be allowed input tax credit for purchase made by the non-filers.

The intention of the amendment is to give a clear message that taxpayers who have not filed VAT returns for over 6 months are not genuine tax payers and are thereby being exposed as defaulters of law. This is not only damaging the social prestige of the non-filers, they are being penalised financially as well and the opportunity for doing business is denied. This has raised a big question about the observance of natural justice by the tax authority. To collect legitimate tax and for administrative convenience, the government has the right to amend acts, rules and regulations, but some basic principles of law also are to be duly observed. Non-observance of the Principle of Natural Justice is one of the most important inconsistencies observed in this amendment in the finance ordinance. Publishing the name of the tax payers in the newspapers thus eroding their social prestige and reputation without issuing prior show cause notice is questionable as the opportunity of being heard is not given to them.

There may be various reasons why the IRD records show the taxpayer as non-filer when he has been filing the returns regularly. It could be mistakes in calculations such as while carrying forward the opening balance. Some times, it is the non-recording/non-updating of the data by the clerks of the IRD. At other times, it may be that application for VAT refund has been made in the VAT returns but it is not accepted by the IRD. There are a number of cases where the VAT return has been filed but not been entered in the IRD database. Though the taxpayer has filed the return in time, he is now going to be penalised only due to the fact that the IRD clerks have not updated the database. One interesting point to be noted is that the IRD never gives a receipt of acknowledgment (Darta number certified in second copy). Instead, a staff member of the office simply puts some ineligible initials while receiving the VAT returns so that it cannot be used as a proof later on in the court.

Similarly, neither the intimation of defective return is given to the tax payer for any arithmetical mistake even though IRD claims to have full fledged computerised database with networking. The present mode of publishing the taxpayer's name and penalising the taxpayer due to IRD's mistake is not justified and is against the principles of law.

In fact, the present system of tax administration is neither made responsible for discharging their duties nor proper legal procedures are being followed during assessments. The cases of beruju detected by the Auditor General are in fact the beruju of the tax officer and not of the taxpayer. For beruju, the responsibility for not conducting the assessment in a proper manner is solely that of the IRD, but surprisingly without clarifying to the Auditor General regarding its basis of assessment, IRD generally forwards the letter of beruju to the taxpayer. The public notice published by the IRD is objectionable and now, the issue is: how can the IRD raise the demand without serving the notice, giving full details of the assessment?

The public notice issued by the IRD states that: "The defaulters have to pay the outstanding dues within 15 days. In case any assessee whose name is being published has already deposited the tax, she/he has to submit the proof of the payment. Otherwise, proceedings under the Income tax Act, 2058 would be initiated against her/him."

The manner of issuing the statement and the words used clearly show the irresponsible behaviour of the IRD. Is it lawful to issue the public notice without sufficient proof? The burden of proof regarding the outstanding due is on the IRD since the department is claiming the dues amount. The notice states that the recovery action shall be initiated under the Income Tax Act, 2058 while the tax dues claimed of the assessment done under Income tax Act 2031 cannot be recovered under Income Tax Act 2058 as per its 143(4). The tax dues published by the IRD are being carried forward for more than 20 years while such dues are time barred. The manner of publishing the notice by the IRD is illegitimate. Individual notices should have been served instead, stating the financial year and the basis of arriving at the dues.

Issuing a public notice without giving the opportunity of being heard is tantamount to the denial of justice. There should be certainty of the tax liability and procedures should be made tax-payer friendly. After a certain period of time there should be prohibition to raise the demand as per the principles of the limitation.

Practical Difficulties due to Provisions of Non-filer & Defaulter in VAT & Income Tax Act

l Tax payer has to approve the vendor list every month whether the supplier/vendor is filer or non-filer.

l Possibility of raising of huge demand by the IRO/IRD while assessing F/Y 2062/063.

l In case input tax credit under the VAT is disallowed, possibility of disallowing expenses booked under income tax as per the present practice of the IRD.

l Total tax effect (VAT & Income Tax) of the same will be more than 70 per cent to 80 per cent of the expenses claimed by the tax-payer if the re-assessment is done after three years by the IRO/IRD.

l In case of the registrant who was non-filer in one month and later on became a filer, the issue of allowing or dis-allowing of input tax credit may be disputed by the IRO/IRD against the taxpayer.

l Apart from maintaining own books of account, now the taxpayer has to be cautious that the supplier too is maintaining proper books of account and filing the VAT returns regularly and depositing the tax. Similarly, he has to be cautious that tax returns filed to the IRD is updated in the IRD database or else penalty may be levied on him for the default of the third party. Thus vicarious liability has been created.