[Piyush is a student at National Law University, Jodhpur.]
The role of directors in the corporate governance structure cannot be understated. Being the flagships of any company, there are certain duties that are intrinsic to their roles. While these duties escaped statutory codification in the erstwhile Companies Act 1956, they are now crystallised in Section 166 of the Companies Act 2013. Amongst the duties this section imposes on directors, one of the most significant duties is the duty to act in good faith and promote the objects of the company for the benefit of its members as a whole. As defined by the JJ Irani Committee, this essentially means that directors must discharge their duties in the best interest of the company and not use their position in an improper manner so as to gain an advantage for themselves or someone else. There are two major approaches or standards in company law jurisprudence across the globe i.e., the subjective and objective approaches. While the subjective standard has been endorsed by the Indian courts, this piece highlights the drawbacks of both the approaches and puts forward a case for a combined subjective-objective approach.
The Subjective and Objective Approaches: What Do They Entail?
The subjective approach, first formulated by British courts, establishes liability based on the subjective state of mind of the director in question. Therefore, a director is said to have complied with his duty of acting in good faith if he acts in what he considers to be in the company’s interest, regardless of how poor or questionable his conduct might be. This approach is perfectly described in the United Kingdom (UK) Court of Appeal in Re Smith & Fawcett Ltd as follows:
“Directors must exercise their discretion bona fide in what they consider, and not what a court may consider is in the interests of the company.”
Subsequently, courts in the UK formulated the objective approach, under which the court first assesses the act based on the relevant circumstantial factors to understand if it is actually in the interests of the company. Once that exercise is undertaken, the court then tests the director’s conduct in relation to that determination - it essentially sees whether the director has acted in a way which is actually in the company’s interests. Alternatively, UK courts apply the test formulated in Charterbridge v. Lloyd Bank Ltd (Charterbridge test) which entails assessing as to whether the director acted in a way that a reasonable man would consider to be in the company’s interest.
It is important to note that these approaches were formulated before directors’ duties were codified in the UK, and the current section in the UK company law lays down a combination of both the subjective and objective approaches.
Drawbacks of Both Approaches
The subjective standard has been subject to intense criticism. Its drawbacks are best encapsulated by the UK Court of Appeal in Hutton v. West Cork Railway Co as follows:
“Bona fide cannot be the sole test, otherwise you might have a lunatic conducting the affairs of the company, paying away its money in a manner perfectly bona fide but completely irrational.”
Thus, the main problem with employing a solely subjective test is that it is too lax- there is ample scope for directors to circumvent liability,[1] even when their conduct is outrightly unreasonable or harmful. By giving such credence to the directors’ unverifiable psychological beliefs regarding the company’s interests, this approach effectively curtails the court from evaluating the merits of and finding ulterior motives in the directors’ conduct. Such flaws are evident in factual matrix of the Bombay High Court case of Balwant Transport Company Limited, Amraoti v. YH Deshpande, wherein a director was held to be acting in good faith when he refused to register the transfer of shares on the ground that the purchaser had relations with the director’s adversary - for the director believed that having him as a shareholder would be detrimental to the company. Further, since the entire premise of this approach is based on the director’s beliefs regarding the company’s interests, it would be completely inadequate where the director did not consider the company’s interests at all before making a decision.[2]
On the other hand, the objective approach subsequently adopted by UK courts is not ideal either. This approach poses the danger of holding directors liable merely because they did not act in a way that the court or a ‘reasonable man’ would consider to be in the company’s interest, essentially giving inadequate deference to the director’s decisions and discretion. Further, the ex post facto analysis undertaken by the courts regarding what is in the company’s interests has a huge possibility of being influenced by hindsight bias- what the court believes to be in the company’s best interests retrospectively could very well differ from what it might have thought to be in the company’s interests at the particular time when the decision was actually made, especially in light of the uncertainty and incomplete information with which business decisions are usually taken. The particular facts of the Singapore High Court case of OP3 International v. Foo Kian Beng perfectly demonstrate this. In that case, the director paid dividends to shareholders even though there was ongoing litigation for substantial damages against the company, based on the lawyers’ assurance that the company had a strong defence and was likely to win the case. However, the company ultimately lost and had to pay a huge sum, rendering it insolvent. Employing the objective standard, the court held the dividend payment to be a breach of the director’s good faith duty. This is a perfect instance of hindsight bias making an assessment of the directors’ duties completely divorced from the commercial reality of uncertainty faced by directors when making business decisions.
Indian Courts’ Stance on the Subjective-Objective Debate
A long line of precedent reveals that Indian courts have always endorsed the subjective standard.[3] This is evident by the Supreme Court’s holding in the case of Bajaj Auto v. NK Firodia (Bajaj Auto). In this case, the directors had refused to register the transfer of shares that were purchased by a certain group believing that transfer sought was part of a male fide design to acquire interest in the company to threaten the smooth functioning of its management. Although the directors were ultimately held liable for not acting in good faith, the court held that the acts of directors would have to be analysed as to whether they were under an honest belief that they were acting in the company’s interest. While an explicit judicial endorsement of the objective standard is lacking, some courts and tribunals can be seen moving towards the same, such as the NCLT in Mar Jacob Thoomkuzhy v. Jeevan Telecasting Corporation Limited, wherein the respondent directors removed the petitioner directors from directorship and started acquiring shares in the company with the ulterior motive of taking over it. Holding the respondents liable, the NCLT held that:
“A director must ensure that his conduct confirms to the standard of a reasonably prudent person.”
However, the subjective standard as endorsed in Bajaj Auto still remains the binding judicial precedent in India. In Nanalal Zaver v. Bombay Life Assurance Co, the need to strike a balance between allowing directors the space to take business decisions as per their commercial wisdom and intervening when their conduct is not bona fide was highlighted. As long as either the subjective or objective approach is exclusively followed, it is evident that this balance will never be achieved.
The Combined Subjective-Objective Approach: The Way Forward?
The flaws prevalent in both the approaches- leniency in the subjective standard and hindsight bias without adequate consideration to the director’s commercial wisdom in the objective one have led courts to strike a balance and formulate a hybrid standard i.e., the combined subjective – objective approach. Such an approach is best exemplified by the Australian case of Bell v. Westpac, wherein the court held that the assessment of the director’s duty is a largely subjective exercise, with a focus on ascertaining whether the director was under the honest belief that his actions were in the company’s interests. To determine the veracity of this belief, and to “accept or discount the assertions directors make about their beliefs”, the court held that the circumstances and surrounding facts of the case are to be probed into objectively.
This exercise avoids substituting the courts’ ex-post facto commercial judgement regarding the company’s interests for the director’s. It also brings in an element of objectivity as it gives the court an opportunity to probe into the facts of the case to decide whether to accept the director’s beliefs as honest or not. Thus, this approach being neither too lax nor too onerous is easily the best available method for assessing a director’s good faith. The merits of this approach are also highlighted by the recent shift towards this standard in other common law jurisdictions.
Conclusion
The diligence with which directors perform their duties would naturally depend on the intensity with which their acts are scrutinised by courts. Indian company directors, being subject to the lax subjective standard have ample space to evade liability for failing to act in good faith. While a departure from this standard would be very welcome, the recent inching towards the objective standard evident in some judgements should not be seen as cause celebre either due to above-mentioned flaws with such an approach. Therefore, the combined subjective-objective approach, if endorsed by the Indian judiciary would not only secure the aim of striking a balance between directorial discretion and appropriate judicial intervention highlighted in Nanalal Zaver, but also ensure that the Indian approach is in tandem with the shift taking place in other common law jurisdictions.
[1] Despotovic, Damjan, ‘Fiduciary Duties and the Business Judgment Rule (with the Emphasis on the Citigroup Case)’ (LLM Thesis, University of Tilburg 2010) p. 36 https://ssrn.com/abstract=1639338. [2] Umakanth Varotill, ‘Directors’ Liability and Climate Risk: White Paper on India (Commonwealth Climate and Law Initiative, 2021) 20 https://ssrn.com/abstract=3936428). [3] Id.