[The following post, the first in a series, is contributed by Rahul Sibal, a third year student of NALSAR Hyderabad. He analyzes possible liabilities that may arise with respect to compensation agreements from different perspectives. He can be contacted at email@example.com. In the following post, he attempts to ascertain the liability of directors, who have entered into compensation agreements, from a common law perspective.]
The Securities and Exchange Board of India (‘SEBI’) has, after seeking public comments on its consultation paper, inserted Regulation 26(6) to the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (the ‘LODR Regulations’) for the purpose of regulating compensation agreements. Put simply, compensation agreements (also known as upside sharing agreements) are arrangements wherein a private equity investor agrees to share a specified portion of the return made on the sale of shares (usually at the time of exit) with the management. It is important to note that the sharing is contingent on whether the profits made cross a stipulated threshold so as to incentivize the management to improve company performance. This results in greater shareholder value. For a better understanding of these agreements, the reader may refer to two posts on the topic available here and here.
While it could be argued that such agreements encourage the management to improve company performance, there exists a risk of the management prioritizing short term goals such as increasing quarterly profits or creating short term capital gains which, although beneficial in the short run, could be financially disastrous for the company in the long term. Given that private equity investments are relatively short term, compensation agreements in effect give primacy to short term considerations. This tendency, commonly referred to as ‘short-termism’, could translate into a scenario wherein the management sacrifices sustainable long term growth to meet short term earning targets.
As noted above, SEBI has sought to regulate compensation agreements by inserting Regulation 26(6), which mandates that such agreements be disclosed to and approved by the Board of Directors as well as public shareholders (a detailed analysis of the regulation can be accessed here). However, the applicability of the regulation is limited to listed companies. Curiously, there seems to be little discussion on the legal ramifications of compensation agreements vis-à-vis private companies, public unlisted companies (or even listed companies prior to the introduction of Reg. 26(6)). For this purpose, I attempt to assess, from a common law standpoint, the liability of directors that have entered into such agreements.
Given that the designation of ‘directorship’ generally involves compliance with fiduciary duties (unlike employees who are required to discharge fiduciary duties in only limited circumstances), two duties that can be argued to be relevant to compensation agreements are the principles of ‘no-conflict’ and ‘no-profit’. The no-conflict rule prohibits directors from placing themselves in a position where their duties towards the company conflict with personal interests or their duties to others. However, an actual conflict is not a pre-requisite: rather a mere possibility of conflict is sufficient for the application of the no-conflict principle. Building upon the discussion on short-termism, the mere entering into of such agreements would give rise to a possibility of the director subordinating company interests to those of the private equity investor, and thus could potentially be violative of the no-conflict rule.
Added to that, it is difficult for directors who have entered into compensation agreements to escape the application of the no-conflict rule since the principle does not allow for the exceptions of ‘good faith’ and ‘scope of business.’ For instance, even if an opportunity realized or profit made by the director could not have otherwise been obtained by the company itself, the mere possibility of conflict would yet result in the application of the no-conflict rule.
It is important to note that Regal (Hastings) Ltd v. Gulliver, a leading precedent on the no-conflict rule, advocated a strict application of the principle. Recognizing that a strict approach could translate into inequitable results, subsequent English cases relaxed the rigor of the rule. However, in the later decision of O’Donnell v. Shanahan the Court of Appeal has reverted to the strict approach enshrined in Regal. Similarly, while Indian courts have not explicitly engaged with the degree of strictness involved in the application of the rule, the Supreme Court’s affirmation of Regal (Hastings) in M/s. Dale & Carrington Invt. (P) Ltd. & Another v. P.K. Prathapan & Others could be interpreted to constitute a preference for the strict approach. The predominance of the strict approach would, in turn, make the imposition of the no-conflict rule to compensation agreements likelier.
Such agreements could also be subject to the no-profit rule, which specifies that any profit earned in the course of fiduciary relationship cannot be retained. In India too, the director’s duty to not make profits at the expense of the company has been recognized. With respect to the pre-conditions for the imposition of the no-profit rule, Lord Cairns LC in Parker v. McKenna observed (albeit in the case of agency):
All that the Court has to do is to examine whether a profit has been made by an agent, without the knowledge of his principal, in the course and execution of his agency, and the Court finds, in my opinion, that these agents in the course of their agency have made a profit, and for that profit they must, in my opinion, account to their principal.'
In consonance with the above observation, courts in both Regal and O’Donnell have held the no-profit rule to be applicable to profits earned via acts undertaken in the course of management, or in other words, in the capacity of a fiduciary. At a primary level, compensation arrangements require the director to improve the performance of the company. Such a requirement, would inevitably involve the director, not in his personal capacity, but in his professional (fiduciary) capacity and would, in the result, trigger the no-profit rule. The no-profit rule parallels the no-conflict rule in terms of its strict approach, wherein the ‘good faith’ and ‘scope of business’ defenses have been held to be irrelevant for the determination of liability under the no-profit rule. In case of a violation of either the no-profit or no-conflict rule (presuming the two doctrines to be distinct), the gains made would be considered to belong to the company and the director would not be allowed to retain the profits made.
However, the effectiveness of the two doctrines can be assailed on the ground that they can only be exercised by the company. Admittedly, a director is a fiduciary of the company and not its individual shareholders. This would translate into an unsatisfactory scenario where directors can enter into agreements that could adversely affect the company’s (and by extension the shareholders’) interest without there being any remedy available to the individual shareholder.
Since the primary difficulty lies in the fact that the two rules can only be exercised by the company and not the shareholder, a possible solution could be the institution of derivative action suits since they are filed by the shareholders on behalf of the company. Interestingly, the Delhi High Court has allowed the institution of a derivative action suit for the purpose of recovering secret profits made in derogation of fiduciary duties codified under Section 166 of the Companies Act, 2013. Duties under Section 166 would be explored in the next post wherein the author analyzes the ramifications of compensation agreements from a statutory perspective.
- Rahul Sibal
[The second part in the series can be accessed here]
[The second part in the series can be accessed here]
 The threshold is usually expressed in terms of the ‘Internal Rate of Return’ (‘IRR’). For instance, it would be stipulated in the agreement that should the return derived exceed the IRR threshold (say 32%), the profits in excess of the IRR would be shared with the management in an agreed proportion.
 The average holding period of private equity investment in India has been 4.4 years for the period 2008-2013. See Pandit, V, Tamhane, T. and Kapur, R., 2015. Indian Private Equity: Route to Resurgence. Private Equity Research, McKinsey & Company, Vancouver.
 From a theoretical standpoint, ‘short-termism’ is known more as an inevitable consequence of the ‘shareholder-centric’ model of corporate functioning than a result of compensation agreements. However, it is argued that compensation agreements exacerbate the tendency of ‘short-termism’.
 V.S. Ramaswamy Iyer And Anr. v. Brahmayya & Co. 1965 Law Suit (Mad) 121. In this case, the Madras High Court relied on Palmer's Company Law (20th Edition) to hold that all powers of the director would be subject to fiduciary duties. Also see Fateh Chand Kad v. Hindsons (Patiala) Ltd, 1927 27 Com Cas 340.
 See Canadian Aero Services v. O’Malley (1973) 40 DLR (3d) 371; University of Nottingham v. Fishel  I.C.R 1462; Shepherds Investment Ltd v. Walters  I.R.L.R 110. Cases where fiduciary duties can be deemed to be applicable to employees would be analyzed in subsequent posts.
 Clark Boyce v. Mouat  1 A.C. 428; National Textile Workers' Union and Ors. v. P.R. Ramakrishnan and Ors. AIR 1983 SC 75.
 Aberdeen Railway Co v. Blaikie Brothers (1894) 1 Macq 461 at 471. Also see Firestone Tyre and Rubber Co v. Synthetics and Chemicals Ltd. and Ors.  41 Comp Cas 377; Shantadevi Pratapsinh Gaekwad v. Sangramsinh P. Gaekwad and Ors., O.J. Appeal No.6/ 1995.
 Regal (Hastings) Ltd v. Gulliver  1 All ER 378; Kak Loui Chan v. Zacharia  HCA 36.
 O’Donnell v. Shanahan  EWHC 1973 (Ch).
 Furs Ltd v. Tomkies (1936) 54 CLR 583, High Court of Australia.
 Island v. Umunna,  BCLC 784; Boardman v. Phipps  UKHL 2.
 Lewin on Trusts, 18th Edition, Sweet and Maxwell para. 20-26.
 Fateh Chand Kad v. Hindsons (Patiala) Ltd, Comp Cas 27 (1957) 340.
 (1874) 10 Ch. App. 96.
 There exists a controversy as to whether the violation of the no-profit rule is contingent on the prior violation of the no-conflict rule. Some commentators have sought to subsume the no-profit rule within the no-conflict rule by casting the no-profit doctrine as a manifestation of the no-conflict rule. See Shue Sing Churk, ‘Just abolish the no profit rule,’ International Company and Commercial Law Review (2015). Others have sought to maintain the distinction, See Worthington, S., 2013. Fiduciary Duties and Proprietary Remedies: Addressing the Failure of Equitable Formulae, The Cambridge Law Journal, 72(3), p.720. However, this debate does not impact the applicability of the two doctrines to compensation agreements.