Monday, April 17, 2017

Ascertaining Legal Ramifications of Compensation Agreements- Part II (Statutory Approach)

[The following post, the second in a series, is contributed by Rahul Sibal, a third year student of NALSAR Hyderabad. In the series, he analyzes possible liabilities that may arise with respect to compensation agreements from different perspectives.  He can be contacted at sibbalrahul@gmail.com. In this second post, he attempts to ascertain the liability of directors that have entered into compensation agreements, from a statutory perspective. The first part of the series can be accessed here]

With the introduction of the Companies Act, 2013 (‘the Companies Act’), the no-conflict and no-profit rules have been codified under sections 166(4) and 166(5) of the Companies Act respectively. However, as indicated by the Irani Committee Report, such codification is partial in nature.[1] Hence, directors could be held liable for breach of fiduciary duties under common law as well as the Companies Act.[2]  While there exists a possibility of the same breach being proceeded against under common law or section 166, the consequences of such breach differ. Remedies under common law include the avoidance of contracts[3] and the recovery of profits[4]  as opposed to section 166(7) which contemplates a fine of one to five lakh rupees for breach of fiduciary duties.

Notably, while commentators have highlighted the strictness of the no-profit and no-conflict doctrines under common law (as discussed here and here), there appears to be no discussion with respect to the rigor of section 166(4). It therefore becomes necessary to ascertain the rigor of section 166(4) before determining its applicability to compensation agreements.

First, section 166(4) codifies common law precedents such as Aberdeen Railway Co v. Blaikie Brothers [(1894) 1 Macq 461] by deeming the ‘mere possibility of conflict’ as violative of the no-conflict rule. Second, while section 175 of the Companies Act, 2006 (‘the UK Act’) also deems mere possibility of conflict as being sufficient to constitute breach, it creates an exception under section 175(4)(a) which qualifies the expression ‘possibly may conflict’ with ‘reasonable’ probability of conflict. In doing so, section 175 accords statutory recognition to the decision in Boardman and Another v. Phipps [1967] 2 AC 46 in which the expression ‘possibility of conflict’ was interpreted as ‘reasonable possibility of conflict.’ Interestingly, section 166 does not provide for this exception.

For these reasons, it could be argued that section 166(4) is more rigorous in its application than the corresponding provisions under the UK Act.[5] Proceeding on this understanding, directors who have entered into compensation agreements could possibly be in breach of their duties under section 166(4). As has been observed earlier, such agreements exacerbate the tendency of ‘short termism’ by incentivizing directors to subordinate the long-term interests of the company to the short-term requirements of the private equity investor. Primarily, such conflict arises due to the short holding period of private equity investments.[6]

In light of this finding, I attempt to find provisions within the Companies Act that would allow companies to authorize such conflicts through shareholder or board approval. While section 175 of the UK Act, which is the corresponding provision dealing with conflict of interests in England, does allow for the authorization of no-conflict breaches through board approval,[7] strangely, section 166 does not contemplate any such exception with respect to the no-profit and no-conflict doctrines enshrined under sections 166(5) and 166(4) respectively. In other words, even if the board of directors (‘the BOD’) and shareholders are amenable to authorizing conflicts or undue profits, there exists no mechanism under the Companies Act for such approval. The absence of approval mechanisms in the Act conflicts with the very basis of common law doctrines of no-profit and no-conflict rule – that of consent. Under the common law, the question of the applicability of the no-profit and no-conflict rules only arises where consent has not been taken from the company. Admittedly, such duties are owed to the company, and for this reason it is the company’s prerogative to consent to violations of fiduciary duties that are owed to it. Common law precedents have implicitly recognized a company’s power to waive its right to proceed against the director through consent. In Parker v. MacKenna (1874) 10 Ch. App. 96 at p. 124, the following observations were made with respect to the no-profit rule:

no agent in the course of his agency, in the matter of his agency, can be allowed to make any profit without the knowledge and consent of his principal; that that rule is an inflexible rule, and must be applied inexorably by this Court……….”

On the same note, in Regal (Hastings) Ltd v. Gulliver it was noted:
                                                     
They could, had they wished, have protected themselves by a resolution (either antecedent or subsequent) of the Regal shareholders in general meeting. In default of such approval, the liability to account must remain.”

These observations make clear that consent would constitute an adequate defense against the no-profit and no-conflict doctrines. Similarly, in Shepherds Investment Ltd v. Walters, at paragraph 127, it was observed that the applicability of the no-conflict rule was premised on the absence of consent. The omission to include authorization provisions in the Companies Act has created two anomalies. First, companies can proceed against directors under section 166 on the ground of breach of fiduciary duties despite according prior consent to such breach. Second, as opposed to codifying common law (as was intended)[8], section 166 has significantly deviated from it.

Unfortunately, there exists no other provision under the Companies Act that could be resorted to for authorizing such kinds of breach. While provisions pertaining to related party transactions [‘the RPT provisions’] allow for authorization of conflicts under section 188, the purview of these provisions is limited to transactions undertaken by the company. Given that compensation agreements are aside agreements undertaken by the director and the private equity investor without involving any transaction on the part of the company, RPT provisions cannot be resorted to.

The only provision that could arguably be resorted to is section 184(1) of the Companies Act, 2013 which reads as follows:
                                                     
Every director shall at the first meeting of the Board in which he participates as a director and thereafter at the first meeting of the Board in every financial year or whenever there is any change in the disclosures already made, then at the first Board meeting held after such change, disclose his concern or interest in any company or companies or bodies corporate, firms, or other association of individuals which shall include the shareholding, in such manner as may be prescribed.

Section 184(1) stipulates that the director must disclose his ‘concern’ or ‘interest’ in any company or body corporate. ‘Interest’, in turn, has been judicially interpreted to convey any personal or financial interest that may conflict with the duties of the director.[9] Given that compensation agreements act as a monetary incentive for directors, such agreements could be said to constitute ‘financial interests’. Hence, there exists a possibility that the disclosure of such agreements under section 184 would accord some degree of protection to such agreements. Although, section 184 merely concerns ‘disclosure’ as opposed to ‘approval,’ such disclosures, if not acted upon by the BOD could be equated with informal consent. Interestingly, in the UK, informal consent has been held to be a valid defence against actions concerning violation of fiduciary duties.[10]

However, there exist strong grounds to reject the applicability of section 184. For one, even if disclosure is equated with ‘informal consent,’ there exists no provision in the Companies Act, 2013 that envisages consent to be an exception to the breach of fiduciary duties as opposed to the UK, where consent, through board approval, is considered to be an exception.  Next, section 184(1) could be argued to be limited in its application to RPTs since it mandates the disclosure of ‘concern or interest in any company or companies………’  While the applicability of section 184 to compensation agreements could be justified on the premise that private equity firms are companies, and that compensation agreements are indicative of an ‘interest’ in such companies, such an argument would constitute a superficial understanding of the nature and scope of section 184(1). An analysis of section 184 reveals that its scope is limited to RPTs, as evidenced by the conditions imposed under sub-section (2) of section 184 that are indicative of such ‘interest’ or ‘concern’ being in the nature of membership or shareholding (as opposed to contractual incentives). It is therefore difficult to assert that compensation agreements could be authorized via section 184.

Thus, it could be argued that the Companies Act does not provide for consent based exemptions as far as fiduciary duties under section 166 are concerned. One possible solution could be to resort to common law defenses. Moreover, it can be argued that common law defenses are not precluded given that section 166(4) is only a partial codification of common law,[11] although it would be difficult to rely on common law for statutory violations. The legality of resorting to common law defenses for the breach of section 166(4) would be analysed in the next post.

- Rahul Sibal




[1] The Report reveals that section 166 was not intended to be exhaustive. Hence remedies could be pursued under common law or the Companies Act, 2013. See ‘Report On Company Law,’ Expert Committee on Company Law (2005), para 18.1, available at http://www.mca.gov.in/MinistryV2/management+and+board+governance.html (Last Visited April 4, 2016).

[2] Ibid, since section 166 is not exhaustive in nature, it could be inferred that common law remedies have not been precluded.

[3] Jacobus Marler v. Marler (1913) 85 L.J.P.C 167; Burland v. Earle [1902] A.C. 83, PC.

[4] O’Donnell v. Shanahan [2008] EWHC 1973 (Ch).

[5] However, Boardman and Another v. Phipps [1967] 2 AC 46 could yet be applied by Indian Courts since section 166(4) is only a partial codification of the no-conflict principle.

[6] 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.

[7] See section 175(6) of the Companies Act, 2006.

[8] See note 1 above.

[9] Mukkattukara Catholic Co. Ltd v.  H.V. Thomas And Ors. AIR 1997 Ker 51. Although this decision was made in the context of Zsections 299 and 300 of the 1956 Act, which were the corresponding provisions to section 184 of the 2013 Act, the ratio of these decisions is equally applicable to section 184 on account of the absence of any substantial change between section 184 vis-à-vis sections 299 and 300 of the 1956 Act.

[10]  Sharma v. Sharma [2013] EWCA Civ 1287.

[11] See note 1 above.

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