Recent news reports (here,
here
and here)
have highlighted a shareholder proposal that has been initiated in preparation
for the annual general meeting of Alembic Limited to be held on 28 July 2017.
The shareholder in question is Unifi Capital Private Limited who is said
(though not verified) to be holding 3% shares in Alembic. The proposal involves
the election of a “small shareholder” director for which Unifi Capital put
forward the name of Mr. Murali Rajagopalachari. Although the company has since
withdrawn the item from the agenda for the shareholders meeting, the
developments have raised the possibility that activist investors could
potentially use the “small shareholder director” route in order to get their
voice heard by resistant boards. Proxy advisory firm IiAS has a detailed
memo on the impact this episode will have on shareholder activism. In this
post, I outline some of the issues pertaining to the “small shareholder
director” and conclude that its utility is likely to be limited, if at all, as
a tool of shareholder activism.
here
and here)
have highlighted a shareholder proposal that has been initiated in preparation
for the annual general meeting of Alembic Limited to be held on 28 July 2017.
The shareholder in question is Unifi Capital Private Limited who is said
(though not verified) to be holding 3% shares in Alembic. The proposal involves
the election of a “small shareholder” director for which Unifi Capital put
forward the name of Mr. Murali Rajagopalachari. Although the company has since
withdrawn the item from the agenda for the shareholders meeting, the
developments have raised the possibility that activist investors could
potentially use the “small shareholder director” route in order to get their
voice heard by resistant boards. Proxy advisory firm IiAS has a detailed
memo on the impact this episode will have on shareholder activism. In this
post, I outline some of the issues pertaining to the “small shareholder
director” and conclude that its utility is likely to be limited, if at all, as
a tool of shareholder activism.
Background and Purpose
The concept of a “constituency
director” is not novel, either in India or elsewhere. Such a director’s
election is attributable to a predefined constituency. A nominee director (proposed
by a controlling shareholder or private equity investor) is a paradigmatic
instance of a constituency director. Similarly, in the Indian context,
directors nominated by banks through powers set forth in specific banking
legislation are another example. However, the idea of small shareholders as a
distinct constituency electing directors is not common around the world, and
India appears to be an honourable exception in providing for a director to be
elected by small shareholders.
director” is not novel, either in India or elsewhere. Such a director’s
election is attributable to a predefined constituency. A nominee director (proposed
by a controlling shareholder or private equity investor) is a paradigmatic
instance of a constituency director. Similarly, in the Indian context,
directors nominated by banks through powers set forth in specific banking
legislation are another example. However, the idea of small shareholders as a
distinct constituency electing directors is not common around the world, and
India appears to be an honourable exception in providing for a director to be
elected by small shareholders.
To be sure, the concept of small
shareholder director existed even under the Companies Act, 1956, although it
was introduced into the legislation by way of an amendment in the year 2000. It
is presently contained in section 151 of the Companies Act, 2013 (the “Act”).
The idea seems to be premised on the need to provide representation and a voice
to the small shareholders who are otherwise passive and apathetic. While it has
been on the statute book for a decade and a half, it has hardly been used.
Given that its potential use as a tool for shareholder activism has been
highlighted, it is useful to consider some of the other features and issues
surrounding the concept.
shareholder director existed even under the Companies Act, 1956, although it
was introduced into the legislation by way of an amendment in the year 2000. It
is presently contained in section 151 of the Companies Act, 2013 (the “Act”).
The idea seems to be premised on the need to provide representation and a voice
to the small shareholders who are otherwise passive and apathetic. While it has
been on the statute book for a decade and a half, it has hardly been used.
Given that its potential use as a tool for shareholder activism has been
highlighted, it is useful to consider some of the other features and issues
surrounding the concept.
Election of a Small Shareholder Director
The bar for the election of a small
shareholder director has been set quite high. Rule 7 of the Companies
(Appointment and Qualification) of Directors Rules, 2014 (the “Rules”) provides
that the lower of 1,000 shareholders or one-tenth of the total number of
shareholders of a listed company may propose the election of a director. Alternatively,
a listed company may, of its own accord, opt to have the small shareholders
elect a director. The Companies Act, 2013 in section 151 defines “small
shareholders” as those holding shares of nominal value of not more than Rs.
20,000.
shareholder director has been set quite high. Rule 7 of the Companies
(Appointment and Qualification) of Directors Rules, 2014 (the “Rules”) provides
that the lower of 1,000 shareholders or one-tenth of the total number of
shareholders of a listed company may propose the election of a director. Alternatively,
a listed company may, of its own accord, opt to have the small shareholders
elect a director. The Companies Act, 2013 in section 151 defines “small
shareholders” as those holding shares of nominal value of not more than Rs.
20,000.
It would certainly be a tall order
for an activist investor to garner the support of such a high number of small
shareholders. It not surprising at all, therefore, to find that small
shareholdings could be “created”, as reported
in the Alembic case. This can be done by orchestrating sales of shares to several
small shareholders so as to generate the constituency required for the election
of such a director. While it is not clear as to who has been behind the process
of disaggregating the shareholding of the company, both an activist investor as
well as incumbent management (or promoter) may indulge in the process, which
will lead to an all-out proxy war. Whether the artificial creation of such
constituencies in the run up to the election of a small shareholder director is
legally permissible is an interesting question. On the one hand, it may be
argued that there is nothing illegal about such disaggregation of
shareholdings, as long as the sales and purchases of shares are otherwise
legitimately carried out. But, on the other, the question arises as to whether
this amounts to vote manipulation. A similar effort in Hong Kong in the context
of a scheme of arrangement was clamped down by a court in the case of Re PCCW Limited ([2009] HKCU 720). But,
the exercise of powers under section 151 neither involve court approval nor are
they through a scheme of arrangement, thereby creating a legal vacuum regarding
the legitimacy of such an approach.
for an activist investor to garner the support of such a high number of small
shareholders. It not surprising at all, therefore, to find that small
shareholdings could be “created”, as reported
in the Alembic case. This can be done by orchestrating sales of shares to several
small shareholders so as to generate the constituency required for the election
of such a director. While it is not clear as to who has been behind the process
of disaggregating the shareholding of the company, both an activist investor as
well as incumbent management (or promoter) may indulge in the process, which
will lead to an all-out proxy war. Whether the artificial creation of such
constituencies in the run up to the election of a small shareholder director is
legally permissible is an interesting question. On the one hand, it may be
argued that there is nothing illegal about such disaggregation of
shareholdings, as long as the sales and purchases of shares are otherwise
legitimately carried out. But, on the other, the question arises as to whether
this amounts to vote manipulation. A similar effort in Hong Kong in the context
of a scheme of arrangement was clamped down by a court in the case of Re PCCW Limited ([2009] HKCU 720). But,
the exercise of powers under section 151 neither involve court approval nor are
they through a scheme of arrangement, thereby creating a legal vacuum regarding
the legitimacy of such an approach.
In any event, such directors are to
be elected by way of a majority of small shareholders, with no other
shareholders eligible to vote for the purpose. Moreover, such election ought to
be conducted through a postal ballot.
be elected by way of a majority of small shareholders, with no other
shareholders eligible to vote for the purpose. Moreover, such election ought to
be conducted through a postal ballot.
Qualification of a Small Shareholder Director
The Rules provide that the person
proposed as a small shareholder director must satisfy all the requirements for
appointment as a director, and ought not to be disqualified under section 164
of the Act. Moreover, the small shareholder director may be considered an
independent director if the requirements under section 149(6) and (7) are
satisfied. This issue may come to the forefront in case of the appointment of a
person who is put up by a significant shareholder such as an activist investor
(as experienced in the Alembic case). Questions could arise whether the board
could have the discretion to determine the suitability of the person for
appointment as a director even if she otherwise satisfies the qualification
criteria. At one level, if the election by the constituency of small
shareholders is to act as an investor protection mechanism, the board must be
left with a fait accompli once a
person is elected to the board by the small shareholders. On the other hand,
section 178 of the Act provides for a broader role for the Nomination and
Remuneration Committee regarding the composition of the board as a whole, and as
to the qualifications and competencies of individual directors. The topical
question would be whether the Nomination and Remuneration Committee can
exercise power under section 178 to determine the suitability of a person
proposed to be a small shareholder director. Arguably, this will come within the
ambit of the Committee’s roles and responsibilities, although how this will
interact with the minority’s choice of director to represent their interests is
unclear. Only a test case will determine how a conflict (or an apparent one)
between the appointment of a small shareholder director (under section 151) can
be reconciled with the terms of reference of the Nomination and Remuneration
Committee to shape the composition of the board (under section 178).
proposed as a small shareholder director must satisfy all the requirements for
appointment as a director, and ought not to be disqualified under section 164
of the Act. Moreover, the small shareholder director may be considered an
independent director if the requirements under section 149(6) and (7) are
satisfied. This issue may come to the forefront in case of the appointment of a
person who is put up by a significant shareholder such as an activist investor
(as experienced in the Alembic case). Questions could arise whether the board
could have the discretion to determine the suitability of the person for
appointment as a director even if she otherwise satisfies the qualification
criteria. At one level, if the election by the constituency of small
shareholders is to act as an investor protection mechanism, the board must be
left with a fait accompli once a
person is elected to the board by the small shareholders. On the other hand,
section 178 of the Act provides for a broader role for the Nomination and
Remuneration Committee regarding the composition of the board as a whole, and as
to the qualifications and competencies of individual directors. The topical
question would be whether the Nomination and Remuneration Committee can
exercise power under section 178 to determine the suitability of a person
proposed to be a small shareholder director. Arguably, this will come within the
ambit of the Committee’s roles and responsibilities, although how this will
interact with the minority’s choice of director to represent their interests is
unclear. Only a test case will determine how a conflict (or an apparent one)
between the appointment of a small shareholder director (under section 151) can
be reconciled with the terms of reference of the Nomination and Remuneration
Committee to shape the composition of the board (under section 178).
These issues are not merely within
the hypothetical realm. Take a case where a company has just the minimum number
of independent directors as required by the Act. If a person proposed by the
small shareholders for appointment under section 151 does not satisfy the
“independence” requirements, her appointment to the board will bring the number
of independent directors below the statutory minimum, thereby resulting in
non-compliance. Can the board (or the Nomination and Remuneration Committee) in
such circumstances refuse to facilitate the appointment of such a person as a
small shareholder director? Alternatively, will it be under any form of
compulsion to appointment the small shareholder director, and follow that up
with the appointment of additional independent directors to bring about the
requisite balance and to comply with the independence requirements? Companies
that face activism through the small shareholder route will have to prepare for
such scenarios.
the hypothetical realm. Take a case where a company has just the minimum number
of independent directors as required by the Act. If a person proposed by the
small shareholders for appointment under section 151 does not satisfy the
“independence” requirements, her appointment to the board will bring the number
of independent directors below the statutory minimum, thereby resulting in
non-compliance. Can the board (or the Nomination and Remuneration Committee) in
such circumstances refuse to facilitate the appointment of such a person as a
small shareholder director? Alternatively, will it be under any form of
compulsion to appointment the small shareholder director, and follow that up
with the appointment of additional independent directors to bring about the
requisite balance and to comply with the independence requirements? Companies
that face activism through the small shareholder route will have to prepare for
such scenarios.
Whose Interests to Serve?
Like the case of nominee directors,
there could be considerable ambiguity if the small shareholder director is
required to serve two masters, namely the company (as an entity) on the one
hand and the small shareholders (collectively as the constituency) on the
other. While the Act makes provision for the election of the small shareholder
director, it does not explicitly lay out the roles, responsibilities, duties
and liabilities of such director. In that sense, the small shareholder director
is no different from other directors, and will be foisted with the array of
duties under company law as applicable to all directors. While there is some
level of segmentation among the director body when it comes to appointments,
which creates a specific mode of appointment for the small shareholder
director, no distinction exists in relation to the roles and responsibilities.
The small shareholder directors’ duties are like that of other directors.
Hence, such a director, once appointed by the small shareholders, cannot simply
advance the interests of her constituents at the cost of the broader interests
of the company and other shareholders. Directors’ duties under Indian law
(albeit under common law and not expressly in statute) are owed to the company
and not to individual shareholders. Hence, while the small shareholders are
entitled to appoint a director, ostensibly protect and advance their interests,
in the end the director so appointed cannot prefer the interests of the
constituents over and above the broader interests of the company. Individuals
being proposed for election as small shareholder directors must be fully
cognizant of the unenviable position they are likely to be placed in. Discharge
of such a role will require a great deal of sophistication and experience.
there could be considerable ambiguity if the small shareholder director is
required to serve two masters, namely the company (as an entity) on the one
hand and the small shareholders (collectively as the constituency) on the
other. While the Act makes provision for the election of the small shareholder
director, it does not explicitly lay out the roles, responsibilities, duties
and liabilities of such director. In that sense, the small shareholder director
is no different from other directors, and will be foisted with the array of
duties under company law as applicable to all directors. While there is some
level of segmentation among the director body when it comes to appointments,
which creates a specific mode of appointment for the small shareholder
director, no distinction exists in relation to the roles and responsibilities.
The small shareholder directors’ duties are like that of other directors.
Hence, such a director, once appointed by the small shareholders, cannot simply
advance the interests of her constituents at the cost of the broader interests
of the company and other shareholders. Directors’ duties under Indian law
(albeit under common law and not expressly in statute) are owed to the company
and not to individual shareholders. Hence, while the small shareholders are
entitled to appoint a director, ostensibly protect and advance their interests,
in the end the director so appointed cannot prefer the interests of the
constituents over and above the broader interests of the company. Individuals
being proposed for election as small shareholder directors must be fully
cognizant of the unenviable position they are likely to be placed in. Discharge
of such a role will require a great deal of sophistication and experience.
Impact on Shareholder Activism
What motivated this post was the
enthusiasm displayed by the media and commentators regarding the use of the small
shareholder director provision in the Act to stimulate greater shareholder
activism. The excitement surrounding the Alembic case is emblematic of the
euphoria, even though in that case the proposal itself may not be put to vote
at the shareholders’ meeting. Given that the Indian company legislation is
somewhat rare in providing for small shareholder directors, the possibility of
its use as a tool of shareholder activism cannot be ruled out. At the same
time, there are considerable limitations with its design and operation.
enthusiasm displayed by the media and commentators regarding the use of the small
shareholder director provision in the Act to stimulate greater shareholder
activism. The excitement surrounding the Alembic case is emblematic of the
euphoria, even though in that case the proposal itself may not be put to vote
at the shareholders’ meeting. Given that the Indian company legislation is
somewhat rare in providing for small shareholder directors, the possibility of
its use as a tool of shareholder activism cannot be ruled out. At the same
time, there are considerable limitations with its design and operation.
At the outset, as discussed
earlier, the bar has been set too high for the proposal and election of small
shareholder directors. Several aspects of the appointment and role of such
director suffer from considerable ambiguity. Even assuming an appointment is
successful in a given case, the small shareholder director is only one among
several directors, and cannot affect the outcome of a board decision. Such
director can be privy to information placed before the board, and can express
views and opinions and seek to convince other directors on matters being
discussed, but would not be in a position to veto any decision. To that extent,
the utility of such a position is to make the voice of various stakeholders
(including the electorate consisting of small shareholders) heard and to infuse
a higher level of transparency in board decision-making.
earlier, the bar has been set too high for the proposal and election of small
shareholder directors. Several aspects of the appointment and role of such
director suffer from considerable ambiguity. Even assuming an appointment is
successful in a given case, the small shareholder director is only one among
several directors, and cannot affect the outcome of a board decision. Such
director can be privy to information placed before the board, and can express
views and opinions and seek to convince other directors on matters being
discussed, but would not be in a position to veto any decision. To that extent,
the utility of such a position is to make the voice of various stakeholders
(including the electorate consisting of small shareholders) heard and to infuse
a higher level of transparency in board decision-making.
More importantly, while the small
shareholder director is an important tool for the protection of “small”
shareholders, necessary care and caution must be exercised to ensure that the
position is not used by one or more large institutional investors who have an
axe to grind with the management or promoters. Without appropriate checks and
balances, the small shareholders may end up acting as pawns in larger corporate
battles amongst groups of influential shareholders (such as a large
institutional investor and the promoters). This will end up compromising the
interest of passive retail shareholders rather than protecting them, which was
the reason for the small shareholder director in the first place.
shareholder director is an important tool for the protection of “small”
shareholders, necessary care and caution must be exercised to ensure that the
position is not used by one or more large institutional investors who have an
axe to grind with the management or promoters. Without appropriate checks and
balances, the small shareholders may end up acting as pawns in larger corporate
battles amongst groups of influential shareholders (such as a large
institutional investor and the promoters). This will end up compromising the
interest of passive retail shareholders rather than protecting them, which was
the reason for the small shareholder director in the first place.
Within the Indian context where SEBI is now increasingly trying its level best to bring in more retail and small investors into the stock market, something has to give, and one is the rigid hold that promoters and cohorts have on listed company even when their own holding is not really very heavy and more importantly promoters have for decades now been playing siphon with company assets. The more relevant case would be the JK-Singhani Group-Raymonds case which the author may also wish to refer to since it also involves a Singapore entity, promoter family spinoff.
The small investor is going to have his way in India because at the end of the day we are still a democracy. And in a democracy, a true democracy, the larger benefit of the small man is what will prevail.