Ascertaining Legal Ramifications of Compensation Agreements- Part III (In Search of Common Law Defences to Statutory Violations)

[The following post, the third in a series, has been contributed by Rahul Sibal, 4th year student of NALSAR Hyderabad.

The first two posts in the series are available here and here.]

In the previous post it was argued that section 166  of the Companies Act, 2013 (the ‘Act’), which partially codified the common law doctrines of no-conflict and no-profit, did not provide for consent-based exceptions. That, it was noted, would constitute an absurd result, given that common law, which is the foundational basis of section 166, envisaged consent to constitute an adequate defence to the derogation of fiduciary duties. By illustration, take the case of director X who enters into a compensation agreement that could possibly conflict with his duty to the company. In this case, the application of the no-conflict rule can be avoided if the company (whether the board of directors or the shareholders in general meeting, as the case may be) authorizes such conflict in the belief that the director’s conflict of interest is not inimical to the company’s interest.

However, as noted earlier, section 166 in its present form does not textually contemplate any exceptions to such violations. Therefore, as things stand, even if director X is authorized to enter into compensation agreements by the company, he could yet be held to be in derogation of section 166. In contrast, section 175 of the UK Companies Act, 2006 (the ‘UK Act’) allows for consent-based exceptions. To address this unsatisfactory situation, we attempt to find defences in common law in the specific context of the no-conflict and no-profit doctrines.

One possible defence could be the ‘Duomatic’ principle. The Duomatic principle protects actions undertaken in contravention of the conditions prescribed in company legislation. The principle takes its name from the case of In Re Duomatic Ltd [1969] 2 Ch. 365. In this case, the corporate liquidators attempted to annul payments by the company to the directors, on the ground that the payments had not been authorized by a shareholder resolution, as was then required under section 191 of the Companies Act, 1948. The court rejected this plea on the premise that all the shareholders had implicitly consented to such payments at the time of approving company accounts.  In the words of Buckley J, as he then was:

In other words, I proceed upon the basis that where it can be shown that all shareholders have a right to attend and vote at a general meeting of the company assent to some matter which a general meeting of the company could carry into effect, that assent is as binding as a resolution in general meeting would be.

                                                                                    [Emphasis Supplied]

Building on the above noted observation, where the articles of association or the relevant companies legislation require approval through a general or special resolution of the shareholders, the absence of such resolutions would not result in the invalidation of company actions if shareholders unanimously consent to such actions. Courts have also admitted the Duomatic principle as an acceptable defence in cases concerning the violation of fiduciary duties. In Sharma v Sharma & Anor (2013), the UK Court of Appeal reached the conclusion that a director had taken up a position that conflicted with her fiduciary duties towards the company. However, having held so, the court concluded that the director had not violated the no-conflict doctrine as enshrined in section 175 of the Companies Act, 2013 since the shareholders had implicitly consented to the  director taking over such a position. In the context of the Duomatic principle, Jackson LJ, observed:

Let me now draw the threads together. I must apply the following principles in resolving the issues in the present appeal. In this summary “statutory duty” means the statutory duty imposed by section 175 of the 2006 Act.

i) A company director is in breach of his fiduciary or statutory duty if he exploits for his personal gain (a) opportunities which come to his attention through his role as director or (b) any other opportunities which he could and should exploit for the benefit of the company.

ii) If the shareholders with full knowledge of the relevant facts consent to the director exploiting those opportunities for his own personal gain, then that conduct is not a breach of the fiduciary or statutory duty.

                                                                                    [Emphasis Supplied]

Given that the Duomatic principle has been recognized and applied in India, it could be employed to protect directors from actions under section 166 if the pre-requisite of shareholder consent is met. However there exist strong grounds to dispute the applicability of the Duomatic principle with respect to actions concerning the derogation of section 166(4) and (5) of the Act. For one, it could be argued that the principle can only be employed to change the mode of consent contemplated under the Act. But where consent-based defences are outside the very contemplation of the legislation, the principle cannot be used. In Madoff Securities International Ltd v Raven & Ors (2013) after a review of past precedents, it was observed by a UK court: “It follows that the Duomatic principle does not permit shareholders to do informally what they could not have done formally by way of written resolution or at a meeting.“

To elaborate, section 175(5) of the UK Act provides for consent-based exemptions through board authorization. Therefore, conflicts of interest that are in breach of section 175 could yet be protected through shareholder approval by the application of the Duomatic principle even in the absence of board authorization. In such cases the Duomatic principle merely alters the mode of consent from board approval to shareholder authorization. For instance, in Sharma (discussed earlier), the director was held to be protected from no-conflict actions, despite the absence of board authorization as required by section 175(5), since shareholders had implicitly authorized the director’s conflict of interest. In contrast, section 166 does not provide for any kind of consent-based defences, thereby rendering the applicability of the Duomatic principle debatable since consent-based defences are outside the very contemplation of the Act.

A more compelling alternative would be to attempt to read common law exceptions into the very concept of ‘conflict.’ In other words, shareholder consent would constitute a pre-condition for the initiation of suits under section 166(4) and (5). Therefore, in contrast to the discussion revolving around the Duomatic principle, wherein the director bore the burden to prove the presence of consent, the burden would lie upon the affected person to prove the absence of consent. While such a line of interpretation would require the reading in of an additional condition that has otherwise not been provided for in the Act, the interpretation finds support in the fact that section 166 is only a partial codification of the no-conflict and no-profit doctrines. Therefore, it could be argued that common law requirements be read independently into section 166.

This interpretation would be consistent with common law precedents that have treated the absence of consent as a pre-condition for the application of the no-profit and no-conflict doctrines. In Parker v. MacKenna (1874) 10 Ch. App. 96, it was observed: 

….we should concur in laying down again and again the general principle that in this court 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.

                                                                                                [Emphasis Supplied]

Similarly, in Mothew (T/A Stapley & Co) v. Bristol And West Building Society (1996), it was held:

A fiduciary must act in good faith; he must not make a profit out of his trust; he must not place himself in a position where his duty and his interest may conflict; he may not act for his own benefit or the benefit of a third person without the informed consent of his principal.

Based on the discussion above, it could be argued that shareholder authorization would protect directors from actions under section 166(4) and (5). However, this line of reasoning too poses certain problems. Conferring shareholders with the blanket power of authorizing conflicts could result in inequitable consequences, especially in the Indian context, where promoters enjoy concentrated shareholding. For example, if conflicts of interest can be protected via shareholder authorization, promoter-directors who are also majority shareholders can protect arrangements that are beneficial to them but inimical to the interests of the company and the minority shareholders.  This difficulty is exacerbated by the fact that Indian Law, like English law, does not impose fiduciary duties on shareholders. In Northern Counties Securities Ltd. v Jackson & Steeple Ltd [1974] 1 W.L.R. 1133, it was observed:

…..when a director votes as a director for or against any particular resolution in a director’s meeting, he is voting as a person under a fiduciary duty to the company for the proposition that the company should take a certain course of action. When a shareholder is voting for or against a particular resolution he is voting as a person owing no fiduciary duty to the company and who is exercising his own right of property, to vote as he thinks fit. . . . . . . . . . . . . . . . . . . . Therefore, the director, in his capacity of a shareholder can vote to authorize his own conflicts of interest that are inimical to the interests of the company.

                                                                                                [Emphasis Added]

In concurrence with the above line of reasoning, courts allowed directors to vote in their capacity as shareholders, to ‘forgive’ their own violation.

As derived from the above discussion, there exist two alternative interpretations of section 166(4) and (5). The first view would be to completely reject consent-based defences. The second option would be to read shareholder authorization as a mechanism to protect directors from actions under section 166. Both interpretations involve undesirable outcomes. The first view would result in directors being in breach of duties prescribed in section 166 despite company consent. The second option would result in interested directors utilizing controlling interest to ratify flagrant breaches. In this background, it is imperative to attempt to arrive at a more balanced understanding of section 166.

The theory of ‘non-ratifiable breaches’ as outlined in Cook v. Deeks can be understood as one such attempt. In this case, the directors diverted a corporate opportunity to themselves. On account of their controlling stake, the directors secured shareholder authorization to protect themselves from actions concerning breach of duties. The approval was set aside on the premise that interested parties could not vote to confer benefits upon themselves. However, the theory of ‘non-ratifiable breaches’, has been criticized^[1]  due to the unclear foundations of the rule. As Professor Gower states in his work,^[2] the theory of ‘non-ratifiable’ breaches does not provide a justifiable rationale for curtailing property rights in shares, since shareholders, unlike directors, are not subject to fiduciary duties. Moreover, Cook (see above) is irreconcilable with precedents such as Northern that have permitted directors to vote in the capacity of shareholders to ‘forgive’ their own breaches. Therefore, the applicability of Cook in India is debatable.^[3]

In view of the above, it is recommended that while companies could accord consent to breaches of director’s duties by taking the stance that section 166 contemplates common law exceptions, it is recommended that such ratifications not involve ‘interested directors’ since the involvement of such directors might incentivize courts to follow the doctrine of non-ratifiable breaches.

In conclusion, it would be profitable for policy makers to observe similar developments in the UK. Despite recognizing the need to bar interested shareholders from voting to ‘forgive’ their own breaches, academics and courts in the UK struggled to impose any restrictions in view of the debates concerning the accuracy of Cooks. Instead, the discussion concerning ‘non-ratifiable’ breaches was sidestepped with the enactment of the Companies Act, 2006 which provided for board approval, as opposed to shareholder authorization.^[4]  Under section 175 of the UK Act, interested directors are barred from voting on ratification of breaches.  This, it is submitted, is the ideal position since it allows companies the autonomy to consent to breaches, and also safeguards the interests of the minority shareholders.

– Rahul Sibal

^[1] Sarah Worthington & Paul Davies. Gower & Davies: The Principles of Modern Company Law. Sweet & Maxwell, 2012, p. 57

^[2] See above, p. 575.

^[3] While the Bombay High Court, in Vadilal Raghavji v. Maneklal Mansukhbhai (1925) 27 BOMLR 48 did note the contrasting dicta, it did not decide on whether shareholder ratification would be effective on the facts of the case.

^[4] The bar against directors, as opposed to shareholders, is justifiable, given that directors are subject to fiduciary duties.