Climate Corporate Governance: Section 166 and an Entity Model

[Rohini is a student at West Bengal National University of Juridical Sciences.]

The initiation of a stakeholder centric form of corporate governance was introduced with the Companies Act 2013, under Section 166(2). This section stipulates that a company’s director shall act in good faith to promote the objects of the company in the best interests of the company, its employees, the shareholders, the community, and for the protection of the environment.

While there is no apparent hierarchy, a ‘pluralist approach’, or the prioritisation of long-term sustainable interests over any short-term shareholder consideration, is represented. In comparison, common law systems like UK follow the stakeholder theory vis-à-vis Section 172, Companies Act (2006), wherein stakeholder interest is merely a means to ‘enhance’ shareholder interest. Therefore, in the event of a conflict, the shareholder interest prevails. 

There are two prominent models in ESG legal frameworks – the ‘financial’ and ‘entity’ based models. The former refers to the involvement of investors and capital as a propelling force for sustainability initiatives over and above a desire or duty to serve the interests of wider stakeholders. The entity model in contrast, places more emphasis on how business operations affect society at large rather than on financial results for investors.

This article argues that Section 166, in the backdrop of sparse judicial interpretation and a post-Ranjitsinh context can pivot into climate-conscious, entity-oriented conception of directors’ duties in Indian law, and that lawmakers must assist in operationalising this latent mandate. 

Dual Approaches and a Judicially Enabled Entity Model 

Section 166’s implication on the one hand, is that directors must identify and mitigate ESG risks, since neglecting to do so may have financial consequences for shareholders. Further, Section 166(3), lays down that a director must exercise duties with diligence and reasonable care. This involves being informed of business risks, which may include ESG risks for climate vulnerable industries. In a general global context, the interpretation of broadly couched duties depends on the ‘environment of expectation’ created by governments and civil society. 

Judicial interpretations of Section 166(2), on the other hand, have tilted towards an entity model. For instance, the Supreme Court, in Tata Consultancy Services Limited v. Cyrus Investments Private Limited and Others ruled that corporations must reflect social accountability, and in the face of conflict, a balance must be sought between private and public interests. The Supreme Court addressed the particular obligation of the directors to take “the protection of the environment” into consideration in MK Ranjitsinh v. Union of India, treating it as being on par with obligations to other stakeholders and shareholders. The Court imported the definition of ‘environment’, under the Environment (Protection) Act, which refers to the “inter-relationship” existing among natural elements, living and non-living beings. 

The Supreme Court in Himachal Pradesh Bus Stand Management v. The Central Empowered Committee, spoke of the ‘environmental rule of law’ as that which integrates science, legal principles, and policy to address climate change, habitat loss, and environmental degradation. Emphasis was placed on the fact that environmental harms like rising sea levels and global warming transcend national boundaries and threaten entire ecosystems, thereby warranting collaboration between stakeholders and collective effort. 

Indian courts have underscored the importance of stakeholder protection even prior to the enactment of Section 166(2). In National Textile Workers’ Union v. PR Ramakrishnan, the court referred to companies as a ‘socio-economic institution’ and not just a legal vehicle for shareholders’ business interests.

While Section 166(2) is starkly different in phraseology from shareholder-centric provisions like Section 172 of the UK Companies Act, and theoretically provides for a sound ESG base, there remains a lack of clarity with respect to the enforcement and contours of Section 166(2)’s ESG paradigms, illustrated in its glaring non-use. 

Two primary challenges are observable – interpretational and enforcement based. Interpretational challenges involve ascertaining the meaning of ‘good faith’ and resolving conflicts of interests between shareholders and stakeholders and the environment. Tata Consultancy by proposing ‘balance’ avoids the question of what the law should prioritise in case a situation of such conflict arises. The enforcement dilemma arises from the fact under the Indian corporate law regime, wherein Section 166(2) affects the rights of stakeholders, the present framework does not allow for a direct suit in that regard. 

'Good Faith' and the Business Judgement Rules

The vagueness around the applicability of the ‘good faith’ condition presents an interpretational issue with this provision. The present test is essentially subjective, to determine if the directors truly ‘believed’ that they were acting in the best interest of the company, members, stakeholders and the environment. The Supreme Court has opined that if directors exercise their powers in a bona fide manner, such exercise must be valid and proper even if it incidentally benefitted them.

Therefore, India's current good-faith test under Section 166(2) is largely subjective, deferring to directors' claimed beliefs about the company's best interests. This threshold, which effectively requires demonstration of bad faith or personal gain, makes it very difficult to hold directors liable for environmental neglect.

Contrarily, courts should apply a more objective ‘good faith’ test, as has been used in Charterbridge Corporation Ltd v. Lloyds Bank Ltd, along the lines of the ‘reasonable belief of an intelligent and honest man’, taking into account circumstance and context. Since ‘climate change’ and its related risks would fall under ‘circumstance’, this method of liability analysis may serve well in balancing even conflicting interests. 

Climate Risk and ‘Best Interest’ of Companies 

Courts have recognised the inseparability of the financial from the social and environmental. For instance, the Gujarat High Court supported the idea that business operates in three different realities - economic, human, and public, in the case of Panchmahals Steel Limited v. Universal Steel Traders. The corporation is a human working community that acts together for the common good, whose reality is far more expansive than that of a capital association. In a similar spirit, the NGT in Aam Janta v. State of Madhya Pradesh, ruled that companies should integrate economic, social, and environmental goals into their operations, with a focus on ‘how’ profits are generated.

By bringing in stakeholder constituencies and the environment to be at par with shareholders and the holistic company, ascertaining a long-term interest is even more complicated. While the current incentive for ESG compliance relies upon SEBI guidelines and investor culture, the broader question of environmental conservation moves to how corporations carry out functions and the effect of these functions. There is complete scholarly and judicial silence when it comes to conflict in director’s liabilities between climate risk mitigation and ‘business interests’. 

Directors are required to give the issue their attention, independent of the related financial ramifications, as evidenced by the fact that ‘environment’ commands its own space in the legislative provision. Further, the exclusion of the ‘drafting style and interpretation as employed in the UK, strengthens this position. For example, in the UK, ClientEarth’s lawsuit against the directors of Shell, asserted that directors had violated their duties to exercise reasonable care, while developing the company's climate change risk management plan. This suit was dismissed twice, due to prima facie non-maintainability and the absence of a specific duty to address climate risk.

On the other hand, in India, in light of Ranjitsinh, Section 166 may be violated by a choice that appears to be in the company's and its shareholders' best financial interests but is in neglect of environmental ramifications in a climate change context. While this would be a laudable direction for courts and Section 166’s jurisprudence, climate corporate governance is far more complex – even within the ESG framework, the prioritisation of environmental concerns could jeopardise the welfare of other stakeholders, like employees. Therefore, even while climate change and the need for environmental restoration must be kept in perpetual backdrop of Section 166(2), the enforcement and tests to determine if a director has failed in this regard must be kept holistic, interdisciplinary and balanced. 

In that light, courts may articulate a structured Section 166(2) inquiry in climate-related cases along the following lines: 

1. Whether the board of directors identified and reviewed the company’s material climate‑related risks and opportunities, subjecting them to periodic review?

2. Whether directors ensured the formulation of a coherent strategy or plan to manage those climate risks, including mitigation, adaptation, and transition risks and did the board exercise active oversight over its implementation?

3. Whether in the formulation or approval of such decisions, the board considered impacts on key stakeholder groups and the environment?

4. Holistically, does the decision fall within the range of options that a reasonable, intelligent, and honest director, properly informed of the company’s climate risks and Section 166(2)’s pluralist mandate, could have adopted on the facts? 

Potential Remedies and Enforcement Barriers

In most cases, the corporation alone has the authority to file a lawsuit for a director's duty violation. In certain situations, shareholders may file a derivative action if the board chooses not to file a lawsuit. However, even these suits have no statutory basis and are very rare given the complications with instituting them successfully. In any case, there is no legal basis for non-shareholder stakeholder constituencies to bring suits. 

Oppression, prejudice and mismanagement (OPM) suits are brought when company affairs are conducted in a manner prejudicial to public interest. Climate and environmental harms readily engage this public interest limb, as a sustained pattern of ignoring material climate risks, particularly in vulnerable sectors like energy or manufacturing, which demonstrably prejudices broader society through accelerated environmental degradation. A failure to comply with ESG requirements or address climate risks may therefore potentially be brought under an OPM suit. 

The other remedy is a class action suit under Section 245, wherein shareholders with a prescribed minimum number of shares may file a suit if they believe that the company's management or operations are being carried out in a way that is detrimental to their interests. For instance, unmanaged climate transition risks, or greenwashing that invite penalties and investor flight may constitute a ‘detriment’ to interest. 

Conclusion

Section 166(2) emerges not merely as a statutory directive but as a potential transformative mandate, compelling directors to transcend shareholder primacy and embed climate imperatives within the corporate conscience. Certain decisions signal courts' readiness to operationalize an entity model, yet persistent doctrinal voids and a gap in enforcement policy has stunted the development of climate corporate governance in India. The orientation of both remedies discussed above cater to a ‘financial model’, depending on shareholder interest and motivation. In an entity model, the primary focus is on the reality of the company’s operation and its environmental impact rather than investor perception or financial result. Perhaps, this is why a recent House Panel recommends the integration of ESG objective under director duties in a new provision. Therefore, a pressing need arises for judicial fortitude to forge an enforceable regime where environmental resilience defines directorial duty.