“Corporate executives are today possessed of immense powers which must be regulated not only for the public good, but also for the protection of those whose investments are involved.”
– William C. Douglas
To shield the interest of various stakeholders, law surveils the conduct of directors by imposing certain duties, which substantially reduces the chance of compromise of interest of the company. There are numerous duties imposed on directors under the basic principle that directors should always work honestly and with reasonable care and prudence considering the knowledge and experience that they have.
Among various other duties, one of the cardinal duties of the director is not to conflict loyalty towards the company and his own personal interest. This implicates that a director should avoid conflict of interest and should not indulge in those transactions where he is directly or indirectly affected because of his self-interest. He should not achieve personal gains by compromising corporate’s interests. By way of this post, an analysis is made on the emergence and evolution of duty of avoiding conflict of interest in India and comparison is made with the United States (“US”) and United Kingdom (“UK”) laws. The suitability of contrasting approaches in different jurisdictions is then examined in the Indian context.
The duty of loyalty can be dated back to a decision of UK court in the case of Keech v. Sanford where the court established duty of loyalty as an important aspect of fiduciary relationship that directors share with the company and its shareholders.
The Companies Act of 1956, (“erstwhile act”) did not provide explicit provisions governing and enforcing duties of a director. The task of codification was done after adopting the recommendations of the JJ Irani Committee. Under Section 299 of the erstwhile act, there was a requirement for a director to disclose any conflict of interest at the meeting of the board. The company was entitled to still enter into a particular transaction provided the interest of director was disclosed and the transaction was made on bonafide and fair grounds. However, concerns were raised in a situation where a large part of Board of directors was interested in the transaction, in such scenarios even when sufficient disclosures were made by them, the board was still guided by their self-interest rather than corporate’s benefit. Thus, a need for a higher threshold to govern directors was realised.
Explicit Codification of Duties in Companies Act, 2013 – A Stricter Approach Adopted
In the Companies Act, 2013, (“Act”) this threshold was increased under Section 166 where “a director of a company shall not involve in a situation in which he may have a direct or indirect interest that conflicts, or possibly may conflict, with the interest of the company”
In contrast to the erstwhile act, this section exempted the director to participate in the meeting so as to maintain fairness and neutrality in the decision. The director was also required to disclose his interest, direct or indirect in the first board meeting in which he takes part as a director as per Section 184 of Act and to avoid any related party transaction under Section 188 of Act.
Director’s Duty to Avoid Conflict of Interest in the US and UK
Different countries have different approaches to govern director’s duties having regard to their corporate structures. In the UK directors act as an agent of the company and exercise wide discretionary contractual powers, whereas, the directors in the US are not considered to be the agents of the company. They work under the realm of a fiduciary relationship with the company. In the US, directors have this relationship and exercise duty only towards shareholders whereas, in the UK, the director has a duty towards an entire corporation including the shareholders.
Duty of loyalty in the US can be traced from the case of Cede v. Technicolor Inc. The court emphasised and examined two fiduciary duties i.e. duty to loyalty and duty of care. The court defined duty of loyalty by saying “Corporate officers and directors are not permitted to use their position of trust and confidence to further their private interests. The rule requires an undivided and unselfish loyalty to the corporation demands that there be no conflict between duty and self-interest.” (here). However, the standard prescribed for the adherence to this duty varies significantly in the US and India. The directors in the US are under no responsibility to withhold themselves from participating in the meetings provided their interests are disclosed as per the procedure laid down by the Model Business Act. Conflicted director’s transaction can be justified if the transaction is fair and is in the best interest of the corporation. Section 144(a) of Delaware Code protects such transactions from annulment. Unless the director has dominated or corrupted the decision, he did not contravene his duty of loyalty. However, it was necessary to prove that the transaction was made in a fair manner and reasonable care was being accounted while entering (here).
The UK follows an objective test to determine good faith and bad faith transaction. Duty of loyalty is known as ‘the no-conflict-rule’ there regulated under Section 175 of Companies Act, 2006 in the UK. The test as laid down by Item Software (UK) Ltd v. Fassihi is to see whether the action or decision of the director has regards to the interest of the company and has reasonable grounds to arrive at such decision. Except if otherwise is provided in the Articles of Association of the company, the law does the refrain the directors to participate or vote in favour of the transaction in which his interest lies, provided he discloses such interest timely.
Indian Perspective – Strict or Pragmatic?
India faces insufficient jurisprudence when it comes to no-conflict rule. Seaworld Shipping and Logistics Pvt. Ltd. v. Kishore Kundanlal Sippy was the only case which attempted to bring clarity in this regard. However, after acknowledging that the directors’ act was mala fide, the court decided in their favour. Perhaps, misapplying the English cases on US position. The Act suggested the strict approach as prevalent in UK laws whereas the abovementioned case endorsed a pragmatic and factual approach as present in the US(here)
Another concern is that the ownership and control in India is not very discrete(here). Almost 90% of private companies are run by families. In such a scenario, where the board is dominated by a few individuals, the need to separate ownership and control was felt to preserve shareholder’s interest and to prevent director’s from making personal gains. Uday Kotak Committee Report suggested various measures to achieve independent board and to separate control from ownership. SEBI, in order to strengthen the corporate governance and to implement Kotak Committee’s Report, introduced an amendment in Securities and Exchange Board of India (Listing Obligations and Disclosure Requirement) Regulations 2015, making it vital for top 1000 and top 2000 listed companies to have half of the independent directors in Board(here). One of the reasons for the failure may be the limited application of these regulations, i.e. on only top 500 – 2000 listed companies; leaving a large chunk of corporates unregulated.
Therefore, it can be concluded that mere disclosure of conflict of interest and lesser stringent approach might be sufficient for the US, considering the role of impersonal investors, active shareholder participation and a higher degree of disclosures. But in the Indian context where the ownership is concentrated with a few individuals, families, promoters etc. who have the power to bend the corporate policies in their satisfaction; it becomes paramount to protect the corporate interest. Clarity in this regard can also be sought by examining case laws such as Foster Bryant Surveying Ltd., and Island Export Finance Limited where the court discarded the burdensome and unrealistic obligations on directors and in effect tried to paint a vivid picture by considering various shades of circumstances in which this rule can be liberally applied.
ABOUT THE AUTHOR
Priyashi Chhajer is a third-year law undergraduate at National Law University, Jodhpur. She is an avid writer and generally writes on corporate legal matters.