The recent decision of the Delaware Chancery court invalidating the grant of performance stock options to Elon Musk awarded by the board of directors of Tesla has re-emphasized the nature of duties entrusted with directors. The directors of a company are its trustees and agents as they are responsible for ensuring the viable, successful, and sustainable operations of the company. By virtue of acting as a trustee or agent, the directors bear a relationship of trust towards the company, hence, the duties owed by them are termed as fiduciary duties.
While it is certain that directors cannot act in their self-interest, there has been some debate on the subject of whose interests are the directors obligated to protect in the conduct of their duties. The relevance of this debate may be understood in light of the diametrically opposite views on ESG investments. For instance, a significant number of US states have discouraged investment decisions based on environmental or social considerations citing that it may lead to loss of financial opportunity. On the other hand, the EU has consistently supported consideration of ESG factors in business decisions. This raises a question; can the management make business decisions to subserve non-shareholder interest at the cost of profitability?
The prevailing norms
In this regard, there are two major normative theories guiding the interpretation and implementation of the duties of directors - the shareholder primacy theory and the stakeholder theory. The shareholder primacy theory, pioneered by Milton Friedman, proposes that in a private enterprise, the shareholders are the owners of a corporation, and the management is its employee, accordingly, the management is directly responsible to the shareholders. The only duty of the management is to serve the interests of the shareholders within the confines of the law. Typically, the interest of the shareholders lies in wealth maximization. Accordingly, the corporate vehicle is treated as a profit-driven entity operating for the benefit of the shareholders.
The stakeholder theory emerged as a response to the shareholder-centric management proposed by the shareholder primacy norm. It focuses on the interests of a wider group of stakeholders including the employees, creditors, consumers and general community. At the core of this theory lies the principle that the corporate entity benefits from multiple factors ranging from the legal system to social structure which directly or indirectly contribute to the functioning of the corporation. Therefore, the management must consider the fundamental interests of all stakeholders irrespective of profitability.
Both the shareholder primacy theory and the stakeholder theory dictate the extent of social responsibility of corporations. Traditionally, legal systems have given primacy to shareholders’ interest over other considerations. Early common law jurisprudence supports the shareholders’ primacy norm by specifying that the purpose of a business enterprise is to make profit for the shareholders (Dodge v. Ford Motor Co., 170 N.W. 668, 684 (Mich. 1919)). The free enterprise model considers financial growth as the primary goal which benefits the shareholders and in turn, may also benefit society, assuming that the limited resources would be put to optimal use ultimately creating wealth for all stakeholders. Therefore, the corporate executives were restricted from considering the interests of the non-shareholder group unless it serves a business purpose.
Shift from shareholders’ value to enlightened shareholders’ value
With the emergence of large-scale corporations serving public utility functions, a view emerged that the purpose of existence of the corporate form cannot be for the sole benefit of shareholders.[¹] There is a general consensus among the business community that the purpose of a corporation is no longer to solely maximize shareholders’ value. Support for this view was expressed at the Business Roundtable held in 2019 where corporate executives from the US released the ‘Statement on the Purpose of a Corporation’ committing value creation for all stakeholders (read here). This statement replaced the earlier statements of the Business Roundtable which stated that corporations exist principally to serve their shareholders.
In view of the changing ideology, while maximization of shareholders’ value is still of importance, there is a growing acceptance for a view that considering the interest of non-shareholder stakeholders contributes to long-term shareholder value maximization, also termed as ‘enlightened shareholders’ value’ (ESV). This marks a shift in the standard of corporate governance by accounting for the welfare of a larger group of stakeholders. The ESV approach is also supported by the business judgment rule which provides protection from personal liability for business decisions made by directors unless it is demonstrably unfair (Aronson v. Lewis, 473 A.2d 805 (1984)). Therefore, the directors are provided with wider discretion to consider non-financial factors in their decisions.
The ESV standard of corporate governance is also given statutory recognition by the UK Companies Act which acknowledges consideration of stakeholders’ interests while making business decisions. Commentators have widely agreed that UK’s ESV model follows a hierarchical approach ensuring that the primary duty of directors still remains to “promote the success of the company for the benefit of its members as a whole”, and in doing so the directors are required to give regard to factors such as long-term consequences, interests of the employees, relationship with suppliers and customers and impact on community and environment.[²] In essence, the ESV model is considered a hybrid between the shareholders’ primacy norm and the pluralist stakeholders’ theory.
Indian position
The Indian Companies Act, 2013 provides for fiduciary duties of directors. Specifically, section 166(2) of the Companies Act provides that the directors must “act in good faith in order to promote the objects of the company for the benefit of its members as a whole, and in the best interests of the company, its employees, the shareholders, the community and for the protection of environment.”
There may be two possible interpretations from the above language, first, the primary duty of directors is to conduct the operations of the company for the benefit of shareholders in a manner which is in the best interest of stakeholders; and second, that there is a positive obligation on the directors to separately consider the interest of the stakeholders while promoting the objects of the company.
The Standing Committee on Finance while commenting on the provision as it was introduced originally in the Companies Bill, 2009 seems to have taken the second position (read here). In its concluding remark on the provision, the report of the Standing Committee provides that “[t]he Committee welcomes the proposed changes with regard to the duties of a director to promote the objects of the company in the best interests of its employees, the community and the environment as well…” Therefore, it appears that the fiduciary duty to stakeholders is considered as a standalone separate duty in addition to the fiduciary duty owed to shareholders.
The limited judicial development on this issue also leans towards the interpretation that there is no hierarchy in the fiduciary duties of directors owed to shareholders and stakeholders. For instance, the Supreme Court of India in Tata Consultancy Services Limited v. Cyrus Investments Pvt. Ltd. and Ors. (2021) noted that the nature of fiduciary duties of a director is a combination of public interest and private interest. It interpreted section 166(2) of the 2013 Companies Act as having three separate fiduciary duties stating that “[s]ection 166(2) also talks about the duty of a Director to protect environment, in addition to his duties to (i) promote the objects of the company for the benefit of its members as a whole; and (ii) act in the best interests of the company, its employees, the shareholders and the community”.
Hence, we understand that under Indian law, the directors have a fiduciary duty to shareholders; stakeholders such as employees and community; and the environment. Naturally, there may be instances of conflict due to the competing interests of each class. In such a situation, resort may be made to the business judgment rule to limit personal liability where the directors’ conduct is fair and reasonable. There are, albeit very few, cases of recognition of discretionary powers of directors by Indian courts. In Needle Industries (India) Ltd. and Ors. v. Needle Industries Newey (India) Holding Ltd. and Ors., (1981), the Supreme Court held that directors have discretion on matters of policy so long as the decisions are made in good faith. The Companies Act also empowers the courts to grant relief to directors for breach of duty if it can be demonstrated that the director’s conduct was honest and reasonable.
Our views
India’s approach to directors’ fiduciary duties is more pluralistic and its scope is wider than EU’s ESV model. However, the enforcement of these duties by stakeholders is unclear as the company law remedy of oppression and mismanagement is only available to shareholders. The courts are also yet to specifically rule on the extent of the duty of care owed to stakeholders including the “community”. The peculiarities of the Indian business landscape can also not be ignored while considering the effectiveness of this model. Reportedly, there are about 600 million micro, small and medium enterprises in India (read here), and 85% of incorporated businesses in India are family owned (read here). Therefore, the assertion that directors have a direct fiduciary duty to the community at large in addition to the duty owed to the company’s shareholders is contestable. In view of this, it will be interesting to see the how the implementation of the wide-ranging fiduciary duties of directors in India unfolds.
Authors: Souvik Ganguly, Shrishti Mishra and Prachi Tandon
The information contained in this document is not legal advice or legal opinion. The contents recorded in the said document are for informational purposes only and should not be used for commercial purposes. Acuity Law LLP disclaims all liability to any person for any loss or damage caused by errors or omissions, whether arising from negligence, accident, or any other cause.
[1] E. Merrick Dodd, Jr., For Whom Are Corporate Managers Trustees?, Harvard Law Review, Vol. 45, No. 7 (May, 1932)
[2] Christopher M Bruner, Corporate Governance in the Common-Law World: The Political Foundations of Shareholder Power, Cambridge University Press (2013); Virginia Harper Ho, “Enlightened Shareholder Value”: Corporate Governance Beyond the Shareholder-Stakeholder Divide, Journal of Corporation Law, Vol. 36, No. 1 (2010)