Monday, October 7, 2013

Companies Act 2013: Fiduciary Responsibility of the Board to Stakeholders

The Code For Independent Directors (Schedule IV of the Companies Act 2013), among other things, describes the role and function of independent directors. It says that one of the roles of independent directors is to "safeguard the interest of all stakeholders, particularly minority shareholders'. Another role is "balance the conflicting interest of the stakeholders".

Section 178 (5) of the Companies Act 2013 provides that "The Board of directors of a company which consists of more than one thousand shareholders, debenture-holders, deposit-holders and any other security holders at any time during a financial year shall constitute a Stakeholders Relationship Committee consisting of a chairperson who shall be a non-executive director and such other members as may be decided by the Board." Section 178 (6)  provides that "The Stakeholders Relationship Committee shall consider and resolve the grievances of security holders of the company". Quite interestingly, although independent directors are responsible to balance the conflicting interest of stakeholders, the Committee may not have independent directors.

Section 177 (9) of the Companies Act 2013 provides that "Every listed company or such class or classes of companies, as may be prescribed, shall establish a vigil mechanism for directors and employees to report genuine concerns in such manner as may be prescribed." As per the Draft Rules, companies which accept deposits from the public and companies which have borrowed money from banks and other public financial institutions in excess of fifty crores rupees (Rs 500 million) shall establish a vigil mechanism.

The Companies Act 2013 has not defined the term 'stakeholder'.

When we read all the provisions together, it appears that the Companies Act 2013 considers shareholders as the primary stakeholder group. Other security holders come next. Some may consider that the Act has considered  employees as stakeholders, because the vigil mechanism covers them. The vigil  mechanism is an important tool for fraud risk management and for monitoring compliance with ethical code. Therefore, in strict interpretation of the vigil mechanism, employees are agents who  protect the interest of shareholders and other security holders by blowing the whistle. The mechanism does not directly benefit employees. Therefore, it is incorrect to say that the Act  considers employee group as one of the stakeholder groups.

The Act requires independent directors to balance conflicting interest of stakeholders. We may interpret that independent directors are required to balance the interest of controlling shareholders and minority shareholders. Thus, the Act requires independent directors to address principal-to-principal issues.

independent directors are also required to balance the interest of  shareholders and other security holders. As per law, the Board has fiduciary relationship with shareholders. It should ensure that funds entrusted to the company by shareholders are used for the benefit of shareholders. Courts, particularly, US Courts do not recognise fiduciary relationship with other stakeholders, even debt holders. It appears that the Companies Act 2013 brings a departure from this established principle. In other words, the Companies Act 2013 requires independent directors and the Board to protect the interest of both the debt holders and shareholders and in a situation of conflict of interest they should endeavour to establish a balance between the two. We have to wait for Court's interpretation of this provision. However, if this interpretation is correct, the provision will definitely make the job of independent directors very difficult. It may be argued that in the long term shareholder's interest is protected if debt holder's interest is protected because unreasonably high gearing affects the valuation of the company and might lead to the demise of the company. But in practice, controlling shareholder group and managers, in order to entrench control, invest in speculative projects particularly when the going is bad. It is difficult to identify the right stage when the independent directors should act to strengthen the scrutiny of new projects.

There are examples galore when bad projects are financed by banks and other financial institutions. It is the primary responsibility of the lender to protect its interest. Often non-performing assets (NPA) arise due to poor internal governance of the lender. It would be inappropriate to make independent directors of the borrower for NPA arising from the failure of the borrower to repay the loan as per agreed terms. A question arises that if the law has not made independent directors responsible to protect the interest of vendors, customers and employees, why should it hold them responsible to protect the interest of lenders. Is it because banks and other large financial institutions are controlled by the government? We do not have the answer.

Stakeholder groups are those that are affected by or can affect the company's operations. Stake holder groups include the local community. The concept of stakeholders in the Companies Act 2013 is quite narrow, presumably because it is difficult to provide legal protection to all stakeholders under the corporate law without creating undue hardship to companies. CSR provisions indirectly protect the interest of the local community. Thus, law makers have not undermined interests of that stakeholder group.


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