[Rishabh Mohnot is a lawyer working in Mumbai and Hrithik Merchant a law student at the National Law School of India University, Bangalore]
With the increasing proliferation of companies and their influence, there is a growing need to understand the responsibilities vested on their decision-makers. The Companies Act, 2013 (“2013 Act”) places a duty of care on the key decision-makers in a company, being the directors, in section 166(3). However, there are considerable lacunae in this provision, which results in a lack of clarity in corporate governance.
In this background, the goal of our paper “§166(3) of the Companies Act, 2013: Filling the Gaps of an Incomplete Provision” is to answer two questions: first, who is the duty of care owed to; and second, what is the standard for such duty?
The right-holder of the duty of care
Section 166(2) of the 2013 Act stipulates that the director’s duty of good faith is to consider the interests of all stakeholders, such as shareholders, employees, the community, and the environment. Contrarily, section 166(3) is silent on who the duty of care is owed to. There are three broad approaches to the question of right-holders: first, the duty is owed to all stakeholders; second, the duty is owed solely to the company and the directors have discretion in assuming this duty towards other stakeholders; and third, the enlightened shareholder value (“ESV”) approach introduced in the UK Companies Act, 2006 (“UK Act”), which states that the duty is owed only to the company but the interests of the stakeholders must be accounted for while making managerial decisions.
We argue that the second approach is cogent in context of section 166(3) for four reasons. First, the mention of stakeholders in section 166(2) and not in section 166(3) reflects the legislative intent to include stakeholders only for the purposes of section 166(2). Second, given the silence of the provision, we must look at the previous regime, i.e., the Companies Act, 1956 (“1956 Act”). Under the previous law, the duty of care was solely owed to the company. Third, the duty of care in India arises due to the trust placed by the company on its directors. There is no such relationship between the directors and other stakeholders. This is in contrast to the UK approach, where Parliamentary discussions explicitly state that the duty of care is not a fiduciary one. Fourth, the duty of care, contrary to what some academicians have argued, is not sub-set of the duty of good faith. The distinct exposition of the two duties clearly highlights their nuances, without one being subsumed by the other.
Further, we argue that even normatively, it is not desirable to read in the ESV approach into section 166(3). The ESV approach attempts to form a middle-ground between the shareholder and stakeholder approach. However, in our opinion, it does little to amend the existing shareholder approach since the duty of care is ultimately owed to the company. Stakeholders cannot bring an actionable claim against directors for not taking their interests into account.
One may argue that ESV approach leads to long-term improvement of the stakeholder interest. However, the relationship between long-termism and stakeholder welfare is indeterminate. Long-term decisions, such as cutting down on salary costs, may not necessarily be in the interests of the stakeholders. Thus, we believe that the shareholder value is not only the legally sound approach to the duty of care, but also the desirable one.
The standard of care
Upon our analysis of the Indian jurisprudence, we find a lack of consistent standard applied by the Indian courts for the duty of care under the 1956 Act. The Rajinder Sachar Committee, set up to make recommendations to the 1956 Act, stated that the standard of care is that of a reasonable man. However, there was no discussion on the same. Even when the Indian courts have asserted that they will apply an objective standard, they have often reasoned their decisions based on the subjective circumstances of the director.
At this juncture, it is crucial to delineate the different approaches for the standard of care. The subjective standard, previously followed in common law, requires the director to act in accordance with her skill and experience. However, the UK shifted to a combination of the subjective and objective standards in their Companies Act 2006. This is embodied in section 174(2)(a), which places a minimum threshold of “general knowledge, skill and experience” reasonably expected of a person carrying out the functions of a director and can be only be raised based on the general knowledge, skill and experience the director already possesses.
The subjective-objective test also finds itself in the business judgement rule of the US and the agency law of India. In the former, there is a presumption that a director is acting in good faith that the actions are furthering the best interests of the company. Any reasonable justification would meet this threshold. The duty of care will only be breached in case of proven bad faith, fraud, or gross negligence. This, in our opinion, is an extremely low threshold since proving bad faith or gross negligence is an onerous burden for the shareholders. The US approach is founded on the principle that barring conflict of interest, the directors are best suited to account for the interests of the company and should be given leeway. We disagree with this approach since even directors acting in good faith should be mandated to adhere to protocol and procedure. The business judgement rule places an unreasonable trust on the directors without having accountability.
The Indian Contracts Act, 1872 lays down the principle of agency in India. Section 212 requires agents to conduct their business in accordance with industry practice (objective element), unless the principal is aware of the agent’s lack of skill (subjective element). Notably, this should be distinguished from the UK standard of care, which can only be increased based on the specific skills of the director.
We propose that the tort law objective standard of “reasonable man” should be imported to section 166(3). Often invoked in suits of negligence, the reasonable man standard requires placing a proxy – a reasonable person, guided by considerations that ordinarily regulate human affairs – in the shoes of the director. Since this is an objective test, it does not require the courts to delve into the mind of the director in question to conclude whether the actions of the director were to best of their abilities or in the best interests of the company. The guiding principle in our standard is proportionality of the procedure followed to the risk at hand. For instance, if a company has a factory treating hazardous substances, the director would be required to ensure higher safety protocols at that factory.
The feasibility of a reasonable man standard raises two questions. First, with reference to whom should the magnitude of risk be measured? Since the corresponding right-holder of the duty of care is the company, the risk evaluated should be with respect to the company. Second, can the reasonable man standard be imported in a corporate governance set-up? We answer this in the affirmative. The 2013 Act lays down the procedure to be followed in different scenarios. These include a list of scenarios where ordinary resolutions of shareholders, special resolutions of shareholders, and simple majority of the board are required. We believe that it is possible to implant the proposed standard on company directors. We propose that when directors make decisions, they should answer two questions: first, what is the possible outcome of the decision; and second, what is probability of the outcome occurring. Based on these considerations, the directors should adopt the requisite procedures.
We argue that the reasonable man standard is more suitable compared to the standards previously discussed. First, the reasonable man standard only inquires the decision-making process, and not the substance of the decision itself. Second, running a company is a risky undertaking and hence a standard of care should be based on the proportion of the risk at hand. Having a standard of care based on substance of the decisions or the subjective circumstances of a director would essentially result in a scenario where every decision is challenged by a disagreeing shareholder. This would stifle the directors’ autonomy and company interests. We submit that director decisions should not held to standard-based on outcomes. It would place an unreasonable standard on the directors and inhibit unconventional management styles. The standard we propose is evenly placed between an abysmally low business judgement rule and an onerous subjective-objective standard of UK Act. The standard we propose gives considerable room for directors’ discretion but at the same time, makes the directors accountable for the procedure they follow.
To conclude, the duty of care provided in section 166(3) of the 2013 Act leaves two questions: the right-holder of the duty and the standard of the duty of care. We argue that legally and normatively, the company is the right-holder. Further, in the absence of specified standard, the reasonable man standard of tort law is best suited to section 166(3).
– Rishabh Mohnot & Hrithik Merchant