Shareholding Patterns and Director’s Duty of Loyalty: Comparative Analysis of India and the US

[Ishani Mookherjee is a 3rd year B.A. LLB (Hons.) student at Jindal Global Law School]

The Delaware Supreme Court, in Cede v. Technicolor Inc., examined the applicability of the business judgment rule in the United States (US). For a business decision to be protected by this rule, two conditions have to be satisfied – the duty of loyalty and the duty of reasonable care. This creates a rebuttable presumption in favour of the directors that they acted on ‘an informed basis, in good faith and honest belief that the action was for the best interest of the company’. This protects the decisions of the directors from derivative claims of shareholders and consequently, from judicial review (Aronson v. Lewis).

The standard of duty of reasonable care is arguably similar in India and the US. In the US, a breach of the duty of care, without any proof of injury, is sufficient (Mills Acquisition Co v. Macmillan Inc). In India, it has been recognized that the director’s conduct must be ‘just, fair and reasonable, according to a reasonable business man, taking a commercial decision beneficial to the company’ (Miheer H Mafatlal v. Mafatlal Industries).

However, the standard of duty of loyalty differs significantly between the US and India. In the Technicolor Case, the Court held that a director’s self-interest is ‘material’ if it creates a ‘reasonable probability’ that it will compromise the independence of a reasonable director and the collective decision of the board. The disloyal director must have ‘either dominated the Board or tainted the presumed independence of the remaining Board members voting to approve the challenged transaction’. The Court relied upon the legislative mandate, under section 144(a) of the Delaware Code, which protects corporate actions from invalidation on grounds of director’s self-interest, if such interest is disclosed to and approved by a majority of disinterested directors and shareholders or if the transaction is found to be ‘fair’ for the corporation (Fliegler v. Lawrence). In this case, the Court held that the interest of the individual directors did not taint the decision of the board, was not ‘material’ and, hence, the duty of loyalty was not breached.

Thus, in the US, if the directors are personally interested in a transaction, they are under no obligation to refrain from participating in the meetings. As long as they disclose their interest truthfully and the transaction is approved by the disinterested directors, the duty of loyalty is not breached and the decision of the board is protected by the business judgment rule. Additionally, even if the rule is rebutted, the directors are not per se liable if they can prove that the transaction was conducted in ‘entire fairness’, in terms of fair dealing and fair price (Nixon v. Blackwell).  

In contrast, the Indian law imposes a significantly higher threshold to ensure that an interested director does not breach his fiduciary duty under section 166 of the Companies Act, 2013. Under section 184, a director interested in a transaction, whether directly or indirectly, is under a duty to disclose his interest at the first board meeting in which he participates as a director, the first board meeting in every financial year and the first board meeting held after a change in interest, even if it is subsequent to the transaction. Moreover, to ensure that the collective decision of the board remains neutral and beneficial for the company, it is imperative for the interested director to not participate in the meeting. Along with penalizing the directors for non-compliance, violation of such provisions renders the transaction voidable by the company.

Under section 299 of the Companies Act, 1956, there was no requirement of interested directors not participating in the meeting, similar to the US law. However, cases like Globe Motors Ltd v. Mehta Teja Singh showed that when a substantial portion of the board becomes interested in some or the other transaction, even when the interested directors disclose their interest and do not participate in the decision-making, their presence is enough to incentivize the entire board to indulge in back scratching, thereby prioritizing their self-interest over the company’s. Such misappropriation of the company’s assets and breach of fiduciary duty necessitated a higher threshold for ensuring independence of the board. So, if the Technicolor Case was to be decided according to the amended Indian law, participation of interested director in the decision-making would itself violate section 184 and render the transaction voidable.

Therefore, with regard to the threshold of ensuring that the interested directors do not breach their duty of loyalty, the US law is more illustrative. Provided that the interest is disclosed and the collective decision of the board is not tainted, the self-interest of the directors is not material. It sets a lower standard as compared to Indian law, which is more prescriptive in nature. The Indian law imposes a duty on the interested director to disclose his interest and to refrain from participating and voting in those transactions. In my opinion, such difference in the threshold set by law needs to be analyzed with respect to the different ownership structures and shareholding patterns of companies in the US and India.

In the US, there has been enormous diversion of stock ownership and shareholding in major companies, as indicated by Berle and Means in their work, The Modern Corporation and Private Property. The principal shareholders owned less than 1% shares. These companies were primarily dominated by several impersonal institutional shareholders, wherein shares were held for investment, by investment groups, insurance companies, etc., rather than individuals. These shareholders did not have any personal interest in the affairs of the company. This ensured that the management of the company was vested with the board of directors, who were not aligned to the personal interests of any one shareholder, consequently differentiating between ownership and control. Similarly, in 1960s, Galbraith, in his work, New Industrial State, highlighted how that the company’s management owned less than 1% shares.

Even with the rise of institutional holdings, ‘controlled companies’, wherein more than 50% of the voting power for election of directors is concentrated in a single entity, constituted a minority among large public companies in America. According to the recent 13F Filings in 2018, the top public corporations continue to be dominated by institutional ownership, wherein shareholding is dispersed among large number of shareholders. For instance, in Apple Inc., institutional ownership constitutes 59.87%, dispersed among over 3,100 shareholders, with Vanguard Group Inc. holding the maximum stake of 6.99%. While individuals like Arthur Levinson and Tim Cook own considerable shares, they are not even among the top shareholders. Similarly, for Amazon.com Inc., institutional ownership constitutes 56.15% shares, dispersed among 2,772 shareholders, with Vanguard Group Inc. owning the highest shares of a mere 5.93%. Jeff Bezos, the top individual shareholder, despite owning 16.1% shares, does not have such a substantial stake to enable him to run the company in accordance with his own interest.

Such trends indicate that an individual or a rich business family can rarely dominate the election of the board of directors and, in turn, control the management of the company. The shares are owned for investment purposes, rather than controlling the management. Consequently, the US law presumes that mere evidence of self-interest, in an otherwise arms-length transaction, does not invalidate the transaction unless the collective decision of the board is tainted. Since ownership is diversified and the shareholders are active, there is a sufficient system of checks and balances on the powers of the directors. In this context, a lower threshold of duty of loyalty and protection by the business judgment rule becomes integral in promoting risk taking.

On the contrary, in the top public companies in India, the majority shareholding is concentrated in the hands of rich influential business families. According to studies conducted by Balasubramanian and Anand in 2010s, despite efforts to ensure diversification of shareholding in markets by mandating a minimum 25% public shareholding, empirical evidence indicated that ownership levels became more concentrated. Throughout 2017, institutional shareholding in family firms decreased, while promoters of family firms continued to dominate the Indian economy.

Likewise, the trend of concentration of shareholding among the promoters is evident from the December 2018 filings. In Reliance Industries Ltd., promoters own 47.19% shares, dispersed among merely 47 entities. Even though shareholding seems to be dispersed prima facie, these entities are mostly relatives and alter-egos of the promoters, indicating concentration of power in the family. Of the remaining 52.81%, owned by 22 lakh public shareholders, foreign portfolio investors own a substantial 23.93%. Even in Birla Corporation Ltd., promoters own 62.90%, through alter-ego corporations and trusts of the promoter family. Similarly, in Tata Consultancy Services Ltd., the promoters own a substantial 72.05% shares, of which Tata Sons Ltd. itself own 72.02%. The remaining 27.95% is owned by seven lakh members of the public.

While promoter ownership indicates confidence of the promoters in the company, concentration of ownership gives considerable power to the rich business families to appoint directors, who could run the management of the company according to their interests, at the expense of interests of the company and public shareholders. Even when shares are issued to the public, most of them are held by foreign investors. Since, in such situations, where a substantial portion of the board may be personally interested in a transaction or may align with the interests of the principal shareholder, having a prescriptive law which imposes a duty on the interested director to not participate in the meeting, after disclosure of interest, becomes crucial to ensure that the collective decision of the board is not tainted.

Therefore, it can be concluded that a merely illustrative law, requiring disclosure of interest by the directors and approval of transaction by disinterested directors, is sufficient in the US context, where ownership is diversified. However, in India, where ownership is concentrated in rich business families and their alter-ego corporations, a prescriptive law requiring the interested directors to not participate in the meetings becomes fundamental to ensure that the fiduciary duty of the board of directors is not compromised.

Ishani Mookherjee

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