Sunday, June 8, 2014

Directors’ Actions: For Whose Benefit?

It is clear that directors ought to act in good faith for the benefit of the company. Since the company is a separate legal personality, there is often the question as to who represents the interests of the company. Generally, the interests of the company are said to equate with the interests of the shareholders, while in the case of an insolvent company (or one that is in the zone of insolvency) the creditors’ interests become paramount. The question whether other stakeholders such as the employees, consumers, and the community and society in general constitute the interests of the company leaves room for some controversy.

Historically, company law in India did not directly address this question. As we have seen before, the Companies Act, 1956 did not spell out directors’ duties and more importantly in whose interests the directors ought to act. While it was generally understood that companies had to cater to shareholder interests, other stakeholders too received some amount of recognition under corporate law. This is because India’s corporate law had been shaped by India’s socialistic origins whereby the role of corporate law extends beyond merely the protection of shareholders. For instance, employees obtain certain special rights under company law, such as preferential payment for dues in case of winding up of a company, and also the right to be heard in case of significant proceedings involving a company such as in a scheme of arrangement (merger, demerger or other corporate restructuring) or in a winding up of the company. Furthermore, as the Supreme Court of India has laid down in the context of mergers, “public interest” constitutes an important element of Indian company law. Affected parties may exercise remedies in case the affairs of a company are carried out in a manner prejudicial to public interest, or if a scheme of arrangement is not in consonance with public interest.

The new Companies Act, 2013 extends the stakeholder principle further while codifying directors’ duties. Section 166(2) provides:

A director of a company shall act in good faith in order to promote the objects of the company for the benefit of its members as a whole, and in the best interests of the company, its employees, the shareholders, the community and for the protection of environment.

Even if there was a doubt under previous legislation as to the extent to which stakeholder interests are to be considered by directors of a company, that has been put to rest in the new legislation. In other words, shareholders are not the only constituency that deserves the attention of directors; other constituencies such as employees and event the community and the environment are to be considered by the directors.

This therefore clearly reinforces the stakeholder principle into corporate law. This is also consistent with the historical understanding of corporate law in India that extended beyond shareholder protection, but it is also buttressed by other provisions of the Companies Act, 2013 such as those relating to corporate social responsibility while enlarge the boundaries of constituencies deserving the attention corporate law and corporate boards.

While this approach is certainly advantageous from a broader philosophical perspective, it could give rise to a number of practical issues that may arise in Indian boardrooms. The attempt in this post is only to set out some of these practical concerns that require further consideration depending upon specific situations that may arise from time to time.

First, directors may be confronted with a conflict between the interests of the shareholders and those of other stakeholders. In that case, whose interests ought to be preferred? For example, if a decision is made that benefits either customers or employees, then they may potentially breach the duty to act in the interests of the shareholders. In such a case, a question arises as to whether the directors have breached their duties to the company giving rise to a legal claim against them.

Such a conflict has been resolved in a different manner when the UK reformed its company law about a decade ago. There, in 1999 the Company Law Review came up with proposals to cater to stakeholder interests. Essentially, two approaches that were considered: (i) the pluralist approach, which states that “company law should be modified to include other objectives so that a company is required to serve a wider range of interests, not subordinate to, or as a means of achieving, shareholder value …, but as valid in their own right”, which represents an expansive conception of stakeholder interest; and (ii) the enlightened shareholder value (ESV) approach, which takes the position that the ultimate objective of company law to generate maximum shareholder value is also the best means of securing protection of all interests and thereby overall prosperity and welfare. In other words, the latter approach conceives of a merger of interests of stakeholders and shareholders by adopting the position that if the company acts to preserve stakeholder interests, then that would necessarily bring about enhancement of shareholder value. However, after some extensive debate, it is the ESV model that has received statutory recognition in the UK. This appears to be a half-way or hybrid approach that is primarily for the benefit of shareholders, but also obliquely takes into account the interests of other stakeholders.  

On the other hand, in the context of the aforesaid dichotomy, the Companies Act, 2013 in India has preferred to adopt the pluralist approach by providing recognition to both stakeholders and shareholders, without necessarily indicating preference to either. In a more practical sense, this means that the directors carry the burden of making the difficult choices in determining the hierarchy of differing interests in a given set of circumstances.

Second, there could potentially be conflicts among the interests of various stakeholders themselves. While shareholders’ interests are generally homogenous (except for differences that could arise between in the controlling shareholders and the minority shareholders), stakeholders could possess vastly differing interests that may require prioritization among themselves. This results in added determination and adjudication responsibilities on the board.

Third, shareholders’ interests are more tangible and measurable than stakeholder interests. Shareholder interests are represented largely by financial parameters of a company that indicate corporate performance (with the most common resultant indicator being the share price of a company) as well as other indicators that may represent corporate governance. Conversely, stakeholder interests are somewhat more intangible and subjective in nature causing decision-making to be more difficult for the board.

Finally, even if some of the aforesaid practical considerations can be addressed through focused board measures and processes, the Companies Act, 2013 does not seem to provide for remedies against breach of directors’ duties to take into account stakeholder interests. Generally, for a breach of directors’ duties, the company could initiate a legal claim against directors. If they fail to do so, shareholders have the right to bring a derivative action against the directors on behalf of the company. However, other stakeholders do not have similar legal claims against companies or boards for breach of duties to act in their interests. Hence, their rights may not be justiciable in nature thereby questioning the extent of their efficacy.

These issues may appear somewhat esoteric to begin with, but they would have to be confronted by corporate boards to face the new reality. They would also figure more prominently if and when legal claims begin to get litigated before the courts for breach of directors’ duties under the new law.

4 comments:

Prof Bala said...

This provision seems destined to attract avoidable litigation exacerbating the already overburdened judicial system.
I wish to offer two possible avenues of interpretation to overcome this problem:
1. In section 166 (2), there is a comma after "members as a whole" and before the enumeration of stakeholders. Would it not be reasonable to assume that this confirms the primacy of members over the rest in terms of directors' obligations?
2. The sequencing of stakeholders in this section is interesting. Employees are mentioned first followed by shareholders and others. Since statute drafting is serious business, it may be argued this sequencing cannot be just arbitrary or casual. Maybe the intention is to provide some guidance to the pecking order of claims of different stakeholders. The precedence of employees over shareholders is also not wholly surprising given the special status this group already enjoys in case of winding up. One may also look up the German case law for precedents since that country's governance code provides for co-determination in corporate affairs, and traditionally has substantial statutory representation for German (now European) workmen on heir supervisory boards.
Either way, we seem to be headed for some (academically) interesting times ahead!

Prakhar Bhardwaj said...

This provision is very interesting indeed. In addition to other observations, this provision will also play out interestingly in the Joint venture context. In most agreements, there is a "reserved items list" whereby consent of one of the directors is required to pass the resolution. These are usually placed to protect the the company's interest who has nominated the director. Good examples of these clauses can be found in the SAT decision of Rhodia SA v SEBI. Given this situation, aren't directors contractually obliged to act in the interest of the nominating company ? This is an interesting dichotomy. The subhkam ventures did well in recognizing that companies need to protect their interests in JVs, though it was obviously in a different context. I think we are set for some exciting times on this frontier !

Prakhar Bhardwaj said...

I think the provision is quite interesting in its formulation of the director's duty to serve the shareholder's "interest as a whole". This could be quite contentious in a JV context whereby directors are appointed to safeguard the interests of the different parties to a JV. One manifestation of this is the "Reserved list", which is a list of strategic items which require the assent of one of the directors. A good example of the same can be found in contract scrutinized in Rhodia SA v SEBI. The importance of these provisions to safeguard interests was an important concern that drove the Subkham ventures Tribunal to state that they did not amount to control. With its precedential value nullified, it will be interesting to see how this plays out!

Umakanth Varottil said...

@Prof Bala. As you mention, there could be some level of litigation on the interpretation of this provision. But, the interpretation you offer, especially in point 1. of your comment is an interesting one. The use of the comma may be determinative, in which case one might even argue that section 166 adopts a position similar to the ESV approach in the UK. Also, the use of the words "members" and "shareholders" separately in the same clause is somewhat unclear as to whether they mean separate things or if they are interchangeable.

@Prakhar Bhardwaj. As regards nominee directors, although they are generally appointed to protect the interest of the investor or joint venture partner that nominated them, in law they still owe duties to the company. In other words, if there is a conflict between the interests of the nominator and those of the company, the company's interests must be preferred by the nominee director. This has also received some recognition by the Bombay High Court in Rolta India Ltd. v. Venire Industries Ltd., [2000] 100 Comp. Cas. 19.