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.

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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