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Directors, Their Power and Duty

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Introduction

It is a common adage that with “great power comes great responsibility”. [1] This is true with respect to any kind of power that someone possesses. But human by virtue of being a social animal is subject to committing errors. In the corporate world, relationships work on the concept of power and dependency. This is because not all members have an equal magnitude of power, thus it becomes imperative to have a set of “principled and coherent” regulations, to account for those who are dependent upon these power holders for the exercise of their interests. [2] A corporation itself cannot make decisions; further, it is a collection of human brains and hence, it is prone to human failings. Hence, it is the law’s aim to thwart or rectify these wrongdoings and maintain an environment of healthy competition and to maintain the interests of dependants. [3]

The concept of exercising a power in benefit of the interested party is called fiduciary duty. It means that in a fiduciary relationship, the act of principle should be in such a manner that it is for the benefit of the beneficiary, and the principle has no interest in it. [4] Any deviation irrespective of the motive or intent will be termed as a breach of fiduciary duty and principle will be liable for it. [5] In an ideal situation, a principle will always work for the best interest of beneficiary; herself being disinterested in it. However, in reality, it is quite impossible to disregard the interest of principle as they also sometimes own a certain amount of corporation’s stock, which may or may not put them in control. [6]

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In a company, all the important decisions are taken by the authorities who exert control over company’s working. These include directors, shareholders with voting powers, officers who look after the company’s day to day operations. [7] It can be an individual or a group of individuals, who exercise this decision making power. All these personalities are called corporate fiduciaries. These fiduciaries have to maintain and cater to the interests of beneficiaries. [8]

Now, while considering any decision, a director has to use her discretion along with the best interest of the company. This magnitude of power confers upon them a sense of responsibility. [9] Thus, the beneficiary becomes dependent upon the power holder for the acts for which the beneficiary has given the power holder its responsibility. [10] It becomes the duty of power holder to execute her power in a way that is best in the interest of the beneficiary. Moreover, they possess information which might not be in public knowledge as well. This relationship of power and dependency is called fiduciary duty. Directors are fiduciaries. [11]

Directors have various kinds of duties. They are subjected to both; statutory and common law duties. Broadly divided, directors have two kinds of fiduciary duties; duty of care and duty of loyalty. [12] These duties can be classified according to objectives that are sought for. These are; “to compel directors to act in accordance with strict terms of their mandate; to compel them to exercise care and skill in carrying out their various functions; to compel them to use their wide discretionary powers in good faith and for proper purposes; and to compel them to act loyally in advancing the interest of the company.” [13] The current paper is concerned with the director’s duty of loyalty.

The author in part I introduce the concept of fiduciary duty and briefly mention the kinds of fiduciary duties. Subsequently, in Part II, the author aims at elucidating the Duty of Loyalty and aims to explain it through landmark cases and distinguished articles. Later in Part III, the author aims to move on the standard of duty of loyalty in India and elaborates upon it by discussing few cases. Further, the author aims to analyse the situation of duty of loyalty in India and tries to find a threshold above which an act can be considered a breach of the duty of loyalty. Finally, in Part V, the author concludes the paper by summing up discussion in the paper.

Duty of Loyalty

Principles of fiduciary duty are founded on the assumption of the capability of power holder to set aside her interests and actually do so, and pursue a “course of conduct” which will suit the circumstances of the dependent and be best for him. [14]

The duty of loyalty bars the conduct of a director that is “deceitful, manipulative or in some sense untrue to the terms of the relationship”. [15] Duty of loyalty demands that the act of director should be of benefitting nature to both their corporation and its shareholders. Thus, betrayal by a director will be taken seriously. [16] Further, merely to achieve the alleged legitimate goals, director cannot take any decision on a path of “deceit, manipulation or broken promises to shareholders”. [17]

The case of Meinhard v Salmon [18] gives the definition of duty of loyalty. The facts of the case are that company was offered a business opportunity regarding unincorporated partnership. Morton Meinhard was a silent partner (plaintiff) and Walter Salmon was an active partner (defendant). [19] Plaintiff was supplier of funds and used to receive the entitled share of profits. Defendant alone had the power to run the building. This represented a fiduciary relationship between them. [20] Subsequently, regarding a project for improvement of a hotel, a joint venture to lease was entered into by both of them. Later on the defendant extended the lease plus entered a new lease agreement without bringing it into the knowledge of the plaintiff. Subsequently, plaintiff claimed for pro-rata share in the lease offer. [21]

The majority decision was given by Justice Benjamin Cardozo. He stated that the threshold of fiduciary duty is far more stringent than the “morals of marketplace”. [22] It is the concept of morality of the highest order. [23] Fiduciaries owe an “undivided” or “finest” duty of loyalty. The threshold is not just honesty, but the punctilio of an honor the most sensitive. [24] Thus, any kind of exception to the duty of loyalty will not be accepted. [25]

The duty of loyalty proscribes disloyalty and self-dealing. [26] The act should be bona fide in nature and shall reflect the corporation’s best interest. [27] Any kind of interest, i.e., director’s or interest of any other person for that matter, where any other person may be a family member or prospective competitor or any organisation which a director is in association with, is prohibited. [28] A question of loyalty of a director arises, it is measured with respect to two categories. First category revolves around the situation where there is a conflict of director’s personal financial interest with the interest of the corporation. [29] Second category includes situations where director’s disloyalty arises for the reasons different from financial conflict of interests between her and the corporation. [30]

A director’s actions shall be in good faith and believes that her actions reflect what is best for the corporation. Thus, if a director’s conduct is intentional so as put her self-interests over the corporation’s or when there is an omission to perform an act which was necessary to meet the threshold of good faith, the director should consider removing herself from the transaction. [31] There should be prevention of the director’s involvement into discussions with opposite corporation unless a full disclosure of concerned director’s interest is made to all the directors and shareholders, who are disinterested. [32] Any further action will depend upon the decision agreed upon by them. In a case where the concerned director is involved with the corporation her company wants to transact, disclosure of all the relevant facts should be done. [33] However, in case of non-disclosure stipulation, the director should consider to opt out of all the discussions and transactions that may happen in future and if need occurs, should also resign so as to help disinterested directors decide without being prejudicial. [34] Although, post complete disclosure, interested director can participate in transaction if approved by the disinterested directors. [35] However, if such transaction is put to question, onus is on the interested director to prove its fairness. Further, criteria for judging a transaction’s fairness for conflict of interest or self-dealing elements [36]; -favourability of the concerned transaction to the corporation and its shareholders; likelihood of the transaction to help further the business activities of the company and; fairness of the approval or ratification process of the decision.[37]

A good example of above-mentioned requirements can be Aberdeen Railways Co. v Blaikie Brothers [38] where the appellant company entered into a transaction with a partnership. The issue was that Mr. Blaikie (respondent) was holding the position of a director in the company and was a member in the partnership simultaneously. [39] Thus, consequently when partnership firm wanted the performance of the contract, company denied it by contending breach of fiduciary duty by the respondent. Hence, the contract was voidable. [40]

The court observed that the ability of entering into a contract depends upon the contracting party’s fiduciary character. A director has a duty to make deals which are in the best interest of the company. [41] Position of a director comes with the duty to benefit the company by sharing all the knowledge and skill that he or she have on that subject matter. Avoidance of self-interest with that of company at any cost is to be maintained. It is immaterial that whether there is one single director or he or she is one of the directors. [42]

Another area where duty of loyalty comes into picture is corporate opportunity. Whenever a director is offered with an advantageous opportunity related to her corporation’s business, duty of loyalty is implied. [43] This is illustrated in the landmark case Guth v Loft, Inc. [44] (Delaware case), where the contention was that instead of making the Pepsi-Cola formula and trademark available to the company; they had obtained it on a personal level by Charles G. Guth, who was the president of the Loft Inc. The Delaware Supreme Court gave the definition of corporate opportunity as [45]:

“…if there is presented to a corporate officer or director a business opportunity which the corporation is financially able to undertake, is, from its nature, in the line of the corporation’s business and is of practical advantage to it, is one in which the corporation has an interest or a reasonable expectancy, and, by embracing the opportunity, the self-interest of the officer or director will be brought into conflict with that of his corporation, the law will not permit him to seize the opportunity for himself…” [46]

Concerned director cannot exploit the opportunity for her own interest before presenting it in front of the corporation. [47] In a case where the advantageous corporate opportunity is beneficial to the corporate, the very first thing that the interested director shall do is to make it conspicuous to the board. [48] Further, a full disclosure shall be made. Later it depends on the board to both give it a green signal and pursue the opportunity or if they do not show any interest in it, it can be pursued by the director. [49]

Standard of Duty of Loyalty in India

Indisputably, directors have the duty to act reasonably and in the best interest of company and beneficiaries. However, the old 1956 Companies Act was devoid of law on duties of directors and hence most of the legal position in India was based on the principles of common law. [50] Paucity of Indian cases on duties of directors was the major reason for unclear statutory stance on fiduciary duties. The new 2013 Companies Act introduced §166 which explicitly mentions the duties of directors. [51] These range from due diligence to not to take undue advantage of the company’s belongings. §166 divided the duties into two classes: “duty of diligence, care and skill and fiduciary duties”. The section not only elaborates upon kinds of duties, but also codifies the consequences to the breach of those duties. [52]

Supreme Court of India (hereinafter, “Supreme Court”) in Marcel Martins v M. Printers and Ors.[53] explained fiduciary duty in detail. Fiduciary duty “…connotes the idea of trust or confidence, contemplates good faith, rather than legal obligation, as the basis of the transaction, refers to the integrity, the fidelity, of the party trusted, rather than his credit or ability…” [54] The definition is applicable to persons placing complete confidence in another for a particular transaction or generally. This is inclusive of informal relations which are based on trust and reliance over another. Thus factors like integrity, trust, confidence, fidelity, good faith and fair dealing comes under the umbrella of fiduciary relations. [55] A very broad interpretation is given to the term fiduciary.

In Life Insurance Corporation of India v Hari Das Mundhra [56], court discussed duty of loyalty. The case pertains to the duty of the director to disclose information regarding the value of shares to the company. British India Corporation Limited (“Corporation”) had purchased some shares earlier on behalf of one director Hari Das Mundhra. He deposited money as a loan in the corporation’s account and purchased shares on corporation’s behalf. [57] This had put him in a controlling shareholding position with voting powers. Later he started withdrawing the money he deposited which led the corporation into a difficult financial situation, so to pull out the corporation from this difficult liquid position, the board decided to sell the shares that were purchased earlier. Corporation entered into an agreement with a group of buyers including Hari Das Mundhra for the purchase of those shares. [58] However, later this group cancelled the agreement. This had put a corporation in a difficult position as it needed an urgent solution to save the corporation. Subsequently, Hari Das Mundhra and few others bought those shares but at lesser rates along with the agreement on the condition of relinquishing the management agency of company with respect to those shares. [59]

It was contended that director Hari Das Mundhra did not make correct statements and exploited the transactions in his interest by not disclosing interests that he had in them. He used his influencing and manipulative position for his own ambitions and led to selling of a large number of shareholdings at prices which were forced along with relinquishment of management agency of the companies holding shares. [60]

Court while holding Hari Das Mundhra liable for breach of fiduciary duty towards the corporation discussed the duty of loyalty. A breach of the duty of loyalty is effectively breaching of trust and committing misfeasance. Court acknowledged that due to varying facts in different cases, there is no exact standard of duty of loyalty. However, there are certain elements to the duty of duty. Firstly, loyalty to a company must be both “in fact and in appearance”. Secondly, conflict of interest between a director and company shall be prevented. Director’s interest should not be over that of company’s interest.

Court then moved to equity principle and noted that if a particular matter is infected by conflict of interest; director should be excluded from the decisions on such matter. Since Hari Das Mundra was an interested party in the group of buyers, opting out was the best option for him but he did take part in the transaction. When the group cancelled the purchase of shares, Hari Das Mundhra failed to advise the board to claim losses in subsequent sales of shares. All these acts were a breach of the duty of loyalty. To protect his own interest, he performed in a way that was prejudicial to the working of the corporation and let it fall into the trap of difficulties.

In Dale and Carrington Invt. (P) Ltd. and Anr. v P.K. Prathapan and Ors. [61] the issue was whether allotment of equity shares done by the Managing director was an act which was not in good faith or in the interest of the company. The court noted that directors are agents of the company. [62] They are the people through whom the acts of the company are performed. Thus, it is imperative for them to “act within the scope of their authority and must disclose that they are acting on behalf of the company.” the court held the managing director to be in breach of the fiduciary duty. [63]

The most recent case is Rajiv Saumitra v Neetu Singh [64], which discusses the fiduciary duty. The plaintiff (Rajiv Saumitra) and defendant no. 1 (Neetu Singh) used to run a company named Paramount Coaching Centre (defendant no. 3). Later some disputes arose between both of them and defendant no. 1 incorporated a new company under the name of K.D. Campus Pvt. Ltd (defendant no. 2). [65] At the time of incorporation of defendant no. 2, defendant no. 1 was director of the defendant no. 3. It was alleged by the plaintiff that defendant no. 1 had used the goodwill of defendant no. 3 to get students in defendant no. 2. He alleged that defendant no. 1 created a conflict of interest by giving primacy to her personal financial interests over the benefits of defendant no. 3. [66]

Court held that defendant no. 1 breached her fiduciary duty as a director under §166 of Companies Act, 2013, which statutorily bars members’ conduct that is conflicting with that of company’s interest. [67] §166 prohibits a fiduciary from “(a) placing himself in a position where his interests conflict with that of the Company: (b) gaining an unfair advantage by breaching duties owed to the Company, (c) failing to act in the best interest of the company.” [68] Using current position of director to manipulate the public to take admissions in defendant no. 2 and exploiting defendant no. 3’s goodwill for her own personal benefits is against §166. [69]

Court then moved on to discuss the fiduciary duty of directors and shareholders. Following are the observations made by the court regarding the duty of loyalty:

  • A director has a duty of loyalty and must act in a bona fide manner so as to prevent conflict of interests. This bars them from transacting in any property which is in conflict with the company’s business, or from initiating a competitive business while acting as a director. [70]
  • It is impermissible for the director to retain any secret profit that she is making at the expense of information that belongs to her company.
  • Conflict of interest between director’s and company’s duties will not be tolerated unless consent is given by the company. [71]
  • Apart from §166 which pertains to duties of directors, the duty of loyalty also includes all those members who have a controlling interest in the matters of the company. This includes shareholders, promoters, and directors.
  • Shareholder too has a duty of loyalty and she should deal with her shares in good faith and for the best interests of the company without putting the company in jeopardy. Ownership of shares gives shareholder an unfettered power to deal with her shares. However, it is not absolute. She has to maintain a balance between her ownership of the shares and her duty of loyalty towards the company. [72]
  • The duty of loyalty differs for each kind of member. A director does not need to balance between these two requirements. Her main concern is to keep the company in benefit and not to make profits out of what truly belongs to the company. [73]

Analysis

From director’s general duty to exercise duties in good faith with diligence, the legal jurisprudence on director’s fiduciary duties has evolved to create specific duties that directors owe to company and shareholders. §166 is a statutory imposition of a duty of loyalty upon directors of a company. It does not have any exception to it. The standard of duty of loyalty differs for each kind of member in a company. In case of directors, the biggest concern is to work for the best interest of the company as well as beneficiaries. In a transaction, the very first step that a director has to take is to identify any conflict of interest between her and the company. After the identification, next step is to bring it to the notice of the board of directors and disclose all the information that she has with respect to the transaction and the interest that she might have in it. This helps the board of directors to further the transaction without any prejudice. Now it depends on the board to decide whether the interested director can continue to participate in the transaction or not. Thus, the threshold for an interested director to breach the duty of loyalty is to disclose the information which is the reason behind her interest in the transaction. In case of corporate opportunities, it becomes the duty of the director to share the information with the company before using her own skills as against the fiduciary duties owned by her towards the company. It is immaterial that it’s benefitting to the company.

Conclusion

As mentioned earlier, power is not absolute. And if the power has come due to people placing confidence in a person, it becomes necessary for that person to act with due care and diligence. A director has numerous duties towards a company and its beneficiaries. Before catering to her own interests, it is her duty to take care of all those people, whose benefits are incumbent upon her decision making. Thus, putting a director through the scrutiny of fairness is a justified process.

References

  1. Jean Voltaire, Adrien Jean Quentin Beuchot &Pierre Auguste Marie Miger, Oeurvres de Voltaire, (Vol. 48, 1832), available at https://books.google.co.in/books?id=-k9SAAAAcAAJ&printsec=frontcover#v=onepage&q&f=false, last seen on 05/02/2018.
  2. Lawrence E. Mitchell, Death of Fiduciary Duty in Close Corporations, 138 University of Pennsylvania Law Review 1675, 1675 (1990), available at http://heinonline.org.ezproxy.nujs.ac.in/HOL/Page?handle=hein.journals/pnlr138&div=65&start_page=1675&collection=journals&set_as_cursor=0&men_tab=srchresults, last seen on 05/02/2018
  3. Gabriel Rauterberg & Eric Talley, Contracting Out of the Fiduciary Duty of Loyalty: An Empirical Analysis of Corporate Opportunity Waivers, 117 Columbia Law Review 1075, 1084 (2017), available at http://www.jstor.org/stable/44288095, last seen on 05/02/2018.
  4. Anurag K. Agarwal, Corporate Governance: Changing Trends in Interpreting Fiduciary Duty, IIMA Working Paper Series, 2, Working Paper Number W.P. Bo. 2013-10-05, Indian Institute of Management, Ahmedabad (2013), available at https://web.iima.ac.in/assets/snippets/workingpaperpdf/12896174642013-10-05.pdf, last seen on 05/02/2018.
  5. Dennis J. Block & Michael J. Maimone, The Duty if Loyalty and the Evolution of the Scope of Judicial Review, 59.1 Brooklyn Law Review 65, 67 (1993), available at https://brooklynworks.brooklaw.edu/cgi/viewcontent.cgi?referer=https://www.google.co.in/&httpsredir=1&article=1983&context=blr, last seen on 05/02/2018.
  6. L.V.V. Iyer, Guide to Company Directors: Powers, Rights and Liabilities & Corporate Social Responsibilities, 255, (LexisNexis, 3rd ed., 2011).
  7. Andrew S. Gold, The New Concept of Loyalty in Corporate Law, 43 University of California, Davis 457, 462 (2009), available at https://lawreview.law.ucdavis.edu/issues/43/2/articles/43-2_Gold.pdf, last seen on 05/02/2018.
  8. American Bar Association, Corporate Director’s Guidebook, 62.4 The Business lawyer 1479, 1497 (2007), available at http://www.jstor.org/stable/40688457, last seen 05/02/2018.
  9. A.C.G, The Fiduciary Duty of Loyalty and Care Associated with the Directors and Trustees of Charitable Organizations, 64.3 Virginia Law Review 449, 453 (1978), available at http://www.jstor.org/stable/1072555, last seen on 05/02/2017.
  10. David S. Ruder, Duty of Loyalty-A Law Professor’s Status Report, 40.4 The Business Lawyer 1383, 1399 (1985), available at http://www.jstor.org/stable/40686693, last seen on 05/02/2018.
  11. Umakant Varottil, Directors’ Duties and Liabilities in the New Era, 5 National Stock Exchange 1, 2 (2014), available at https://www.nseindia.com/research/content/res_QB5.pdf, last seen on 05/02/2018.

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