Toothless Legislation: The Gaps in Director’s Duty to Promote Stakeholder Primacy in Indian Corporate Law

Introduction

The corporate purpose debate centers on a fundamental question in company law, for whose benefit should companies be run? This question can be answered with two theories. The shareholder theory¹ argues that companies should maximise financial benefit for shareholders, while the stakeholder theory² advocates for considering the interests of broader groups, including employees, creditors, consumers, the environment, and the community. This debate significantly impacts the interpretation of director’s duties. Traditionally, these duties focused primarily on maximising shareholder profits. However, recent legal reforms in countries like India and the UK have expanded director’s responsibilities to encompass a wider range of stakeholders affected by company decisions.

The Parliament adopted a different approach than the UK³ through Section 166(2) of the Companies Act, 2013⁴. This provision appears to impose a duty on directors to consider non-shareholder interests as well, rather than merely as a means to benefit shareholders. Section 166(2) embraces a pluralist approach, treating the interests of shareholders and other stakeholders as equally important, without establishing a hierarchy. The argument of this paper is that, although Section 166(2) of the Act appears to broadly address the interests of non-shareholders in relation to director’s duties and aligns with the pluralist stakeholder theory, a closer examination reveals significant limitations in practice leading to its inefficiency.

The gaps in the Indian framework leading to inefficiency in protecting stakeholder interests

Prior to the introduction of Section 166(2), Indian courts have expressed their views on the importance of stakeholder protection. In National Textile Workers’ Union v. P.R. Ramakrishnan⁵, the Court rejected the notion of a company as mere a legal tool for shareholders to conduct business. It emphasised that companies should now be seen as social organisations instead. The Court argued that corporate responsibility goes beyond the traditional focus on the relationship between management and shareholders, extending its scope to include a wider range of stakeholders affected by the company’s operations strengthening the view that companies should now be viewed as socio-economic institutions.

However, despite this evolving perspective, scandals like the Sahara case⁶ highlighted the need for a formal law to be in place. The Sahara Group in its extraordinary general meeting (EGM), resolved to raise funds through unsecured optionally fully convertible debentures (OFCDs) via private placement to select individuals connected to the group, without any public advertisement. Sahara India issued these OFCDs as an open-ended scheme, collecting Rs 19,400.87 crores. Such cases prompted the J.J. Irani Committee to emphasise the need for a regulatory framework that aligns with the emerging economic landscape, promotes good corporate governance, and safeguards the interests of investors and other stakeholders.⁷

Section 166(2) states that the duty of directors is owed not just to the company, but also to other stakeholders taking a pluralistic approach but, it raises questions like who should the director prioritise in situations of conflict of interest between the shareholders and stakeholders. An additional question arises as to whether stakeholders have any rights to take action in case of a breach of duty.⁸ In contract, the UK model is quite different. They have introduced the enlightened shareholder value model through Section 172 of the UK Companies Act, 2006. This model requires directors to consider non-shareholder interests with the aim of enhancing long-term shareholder value. Although it combines elements of both shareholder and stakeholder theories, in cases of conflicting interests, it prioritises shareholders, establishing a hierarchy.

On surface level, a comparison of the statutory provisions in India and the UK reveals a significant difference in how stakeholders are treated as beneficiaries of director’s duties. While India appears to have embraced a pluralist approach, the UK adheres to the enlightened shareholder value (ESV) model and as a result, stakeholders in India may enjoy better protection compared to those in the UK. In reality, there are significant barriers which in fact provides even less protection to stakeholders in India than in the UK.⁹

Despite the recognition of director’s duties toward stakeholders under Section 166(2), there is an evident lack of mechanism for the stakeholders to seek remedy. In cases of breaches of director’s duty, the Companies Act provides for a class action suit under Section 245¹⁰, allowing members or depositors to sue directors for failing to fulfil their obligations.¹¹ However, this provision is restricted to situations where the management’s actions are detrimental to the company, its members, or depositors. The scope for exercising these rights is further limited by Section 245(10), which states that only those directly affected, such as individuals, groups, or associations representing them, can bring a suit. This indicates that the law provides remedies only to affected parties, preventing any member from filing lawsuits on behalf of other stakeholders.¹² Even if class action suits are pursued in the future, the provision focuses on protecting the financial interests of those directly involved with the company, offering little recourse for stakeholders through an indirect action.¹³ Moreover, even if shareholders take up the concerns of non-shareholders, they are likely to prioritise their own interests when conflicts arise with other stakeholders.¹⁴

Furthermore, Section 166 of the Companies Act having certain similarities with Section 172 of the UK Companies Act appears to incorporate fiduciary duties rooted in common law principles, but the Companies Act is a complete Code and any breach of these duties results in a financial penalty.¹⁵ However, this also creates a conflicting viewpoint that if these codified duties are viewed as exhaustive, the scope of a director’s responsibilities becomes limited, as the Companies Act does not make any mention of fiduciary duty explicitly and therefore, constrains the application of common law principles when interpreting these duties.¹⁶ But in Rajeev Saumitra v. Neetu Singh¹⁷, the Court did not limit its interpretation to the Companies Act, but expanded the scope of director’s fiduciary duties by referencing Foster Bryant Surveying Ltd. v. Bryant¹⁸. It emphasised that a director’s fiduciary obligations include loyalty, good faith, and avoiding conflicts between duty and self-interest. The Court affirmed that directors must prioritise the company’s interests and act in a manner consistent with these broader fiduciary principles.

An interpretational challenge with this section is the ambiguity around the application of the “good faith” qualification.¹⁹ Specifically, it is unclear whether the “good faith” requirement applies only to promoting the objects of the company for the benefit of its members (first part of the section), or if it also extends to acting in the best interests of the company, its employees, shareholders, the community, and the environment.²⁰ The best interpretation seems to be that it casts a duty on directors that is owed to the company. To effectively discharge this duty, directors must act in order to promote the objects of the company, in the best interests of the company as well as other stakeholders.²¹ If we were to interpret it to mean the other way, it could result in a disaster as balancing the often competing interests of different stakeholders and shareholders leaves directors with substantial discretion.²² This raises the risk that directors may use this discretion to prioritise their own self-interest over the interests of the company and its stakeholders. This could potentially dilute the intended protections for stakeholders.²³

Potential solutions

Snehita Singh²⁴ proposes that director remuneration should be tied to their performance towards effectively serving stakeholders and that the current compensation structure does not adequately incentivise directors to prioritise long-term sustainability. However, this solution may not be the most effective, especially in the Indian context. Section 135 of the Act²⁵ requires certain companies to spend 2% of their net profits on corporate social responsibility (CSR) activities, but this only applies once they reach a certain revenue threshold.²⁶ The companies that are already large enough to meet this requirement are typically the ones that already pay their directors well. As a result, linking director pay to sustainability efforts may not have a significant impact, since the directors of these large, high revenue companies are already being compensated generously. The proposed solution may be less impactful in driving sustainability-focused behaviours.

Rather than solely focusing on director remuneration, a stakeholder-centric approach could be more useful. Stakeholder engagement mechanisms serve as a preventive, ex ante form of accountability²⁷, shaping decision-making to better protect stakeholder interests, especially for long-term outcomes that are difficult to evaluate.²⁸ Providing stakeholders with participation opportunities at various stages of the decision-making process can build trust,²⁹ improve communication, and enhance transparency between a company and its key stakeholders.

Additional solution could be transparency.³⁰ A stakeholder-centric disclosure could also improve governance. While investors may prioritise disclosures protecting their interests, broader stakeholder-focused disclosures can provide long-term benefits to the company, such as legitimising operations and reducing conflicts and costs.

Finally, being mindful of stakeholders could be beneficial in the long run as Larry Fink has stated in his letters to CEOs, business cannot prosper in the long run if the earth or the community are on fire, or if employees are dissatisfied. Businesses cannot succeed in isolation.³¹

Conclusion

This paper has argued that despite Section 166(2) of the Companies Act seemingly embracing a pluralist approach to corporate governance, its practical implementation falls short of providing meaningful stakeholder protection. While the Indian framework appears stakeholder friendly in theory, it contains significant gaps leading to ineffective stakeholder interest protection. Although India’s legislative intent favours a stakeholder-inclusive approach, the practical application of the Companies Act fails to fully realise this vision, highlighting the need for further reforms.