[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 protected]. In
the following post, he attempts to ascertain the liability of directors, who have
entered into compensation agreements, from a common law perspective.]
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 protected]. 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[1] 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.
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[1] 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,[2] compensation agreements in effect give primacy to short term
considerations. This tendency, commonly referred to as ‘short-termism’,[3] could translate into a
scenario wherein the management sacrifices sustainable long term growth to meet
short term earning targets.
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,[2] compensation agreements in effect give primacy to short term
considerations. This tendency, commonly referred to as ‘short-termism’,[3] 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.
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[4] (unlike employees who are
required to discharge fiduciary duties in only limited circumstances),[5] 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.[6] 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.[7] 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.
required to discharge fiduciary duties in only limited circumstances),[5] 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.[6] 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.[7] 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’[8] and ‘scope of business.’[9] 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.[10]
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’[8] and ‘scope of business.’[9] 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.[10]
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.[11] 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.
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.[11] 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.[12] In India too, the
director’s duty to not make profits at the expense of the company has been
recognized.[13]
With respect to the pre-conditions for the imposition of the no-profit rule, Lord
Cairns LC in Parker v. McKenna[14]
observed (albeit in the case of agency):
no-profit rule, which specifies that any profit earned in the course of
fiduciary relationship cannot be retained.[12] In India too, the
director’s duty to not make profits at the expense of the company has been
recognized.[13]
With respect to the pre-conditions for the imposition of the no-profit rule, Lord
Cairns LC in Parker v. McKenna[14]
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.’
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),[15] the gains made would be considered
to belong to the company and the director would not be allowed to retain
the profits made.
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),[15] 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.
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.
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.
[1]
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 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.
[2]
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.
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.
[3]
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’.
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’.
[4]
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.
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.
[5]
See Canadian Aero Services v. O’Malley
(1973) 40 DLR (3d) 371; University of
Nottingham v. Fishel [2000] I.C.R 1462; Shepherds
Investment Ltd v. Walters [2007] I.R.L.R 110. Cases where fiduciary duties
can be deemed to be applicable to employees would be analyzed in subsequent
posts.
See Canadian Aero Services v. O’Malley
(1973) 40 DLR (3d) 371; University of
Nottingham v. Fishel [2000] I.C.R 1462; Shepherds
Investment Ltd v. Walters [2007] I.R.L.R 110. Cases where fiduciary duties
can be deemed to be applicable to employees would be analyzed in subsequent
posts.
[6]
Clark Boyce v. Mouat [1994] 1 A.C.
428; National Textile Workers’ Union and
Ors. v. P.R. Ramakrishnan and Ors. AIR 1983 SC 75.
Clark Boyce v. Mouat [1994] 1 A.C.
428; National Textile Workers’ Union and
Ors. v. P.R. Ramakrishnan and Ors. AIR 1983 SC 75.
[7]
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. [1971] 41 Comp
Cas 377; Shantadevi Pratapsinh Gaekwad v.
Sangramsinh P. Gaekwad and Ors., O.J. Appeal No.6/ 1995.
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. [1971] 41 Comp
Cas 377; Shantadevi Pratapsinh Gaekwad v.
Sangramsinh P. Gaekwad and Ors., O.J. Appeal No.6/ 1995.
[8]
Regal (Hastings) Ltd v. Gulliver
[1942] 1 All ER 378; Kak Loui Chan v.
Zacharia [1984] HCA 36.
Regal (Hastings) Ltd v. Gulliver
[1942] 1 All ER 378; Kak Loui Chan v.
Zacharia [1984] HCA 36.
[9]
O’Donnell v. Shanahan [2008] EWHC
1973 (Ch).
O’Donnell v. Shanahan [2008] EWHC
1973 (Ch).
[10]
Furs Ltd v. Tomkies (1936) 54 CLR 583,
High Court of Australia.
Furs Ltd v. Tomkies (1936) 54 CLR 583,
High Court of Australia.
[11]
Island v. Umunna, [1986] BCLC 784; Boardman v. Phipps [1966] UKHL 2.
Island v. Umunna, [1986] BCLC 784; Boardman v. Phipps [1966] UKHL 2.
[12]
Lewin on Trusts, 18th Edition, Sweet and Maxwell para. 20-26.
Lewin on Trusts, 18th Edition, Sweet and Maxwell para. 20-26.
[13]
Fateh Chand Kad v. Hindsons (Patiala)
Ltd, Comp Cas 27 (1957) 340.
Fateh Chand Kad v. Hindsons (Patiala)
Ltd, Comp Cas 27 (1957) 340.
[14] (1874)
10 Ch. App. 96.
10 Ch. App. 96.
[15]
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.
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.
