Transposing the Business Judgement Rule into Indian Corporate Jurisprudence

Isha Khurana is a 4^th year law student, at Jindal Global Law School

Introduction

The business judgement rule (hereinafter, rule) is a presumption that the directors of a corporation take informed decisions, in good faith and under the belief that they are acting in the best interests of the company. However, traditionally, the rule was devised as a standard to be applied to publicly held corporations. Thus, the legal fraternity must debate on its application in the Indian business environment, which is dominated by closely held corporations.

Closely held corporations have been described as those companies where management and ownership share a stark resemblance, to the extent that they are almost identical, due to which the independence of directors in that company remains a myth. Seeing as Indian companies do not conform to the conventional vision of having ownership that is separate from management either, due to the presence of family run businesses and companies with concentrated shareholding, one can put forth the argument that several Indian companies are in principle, closely held corporations. Additionally, since several companies are privately owned, there would be a restriction on the transfer of shares due to the small number of shareholders and a substantial role of the majority shareholders in the decision-making processes, making it reasonable to categorize such companies as closely held corporations.

Seeing this unique business structure in India, one must question whether the business judgement rule in its traditional understanding is a suitable standard to be applied in Indian corporate jurisprudence? This paper argues otherwise to state that while the core of the rule must be transposed in terms of the duties imposed upon a director, the application and level of scrutiny adopted must be modified to meet the needs of Indian companies.

India’s Closely Held Corporations

The rule relies on the assumption that the management stands different from the ownership and is modelled to meet the needs of the publicly held corporation that has such a management structure in place. Due to this assumption, it would not be feasible to apply the exact same level of scrutiny in cases of a closely held corporations as they are fundamentally different from a publicly held corporation.

The rationale for requiring such a stricter level of scrutiny can be found in the argument that if a relaxed application of the business judgement rule works against aggrieved shareholders, there are alternate course of actions that can be adopted by shareholders in publicly held corporations, which does not necessarily hold true for closely held corporations. For instance, shareholders in a publicly held company can always resort to a sale of their shares and in situations of a takeover, can also use options such as squeeze out provisions to their benefit. Unfortunately, shareholders of closely held corporations have no such recourse. In this manner, if a relaxed approach to the business judgement rule were to be applied with closely held corporations as well, it would lead to more severe cases of oppression.

Thus, the directors in India must be subject to stricter scrutiny. The next section of this paper attempts to discuss the alternate possibilities that can bring about this stricter degree of scrutiny.

Suggestions for an Indian Business Judgement Rule

Traces of the business judgement rule can be found in Section 166 (3) of the Companies Act, 2013. The legislation provides that directors of a company “shall” exercise their duties with due care and diligence and mandates independent judgement. The author would like to point out the use of the word “shall” and draw a distinction between this mandatory obligation on directors vis-à-vis the presumption in favour of the director’s diligence and judgement in the American context. It can be argued that Indian law does impose a duty on directors to disclose their interest in a transaction and places the initial burden of proof onto the directors to show that they took decisions keeping in mind the company’s best interests. The proactive approach of the Indian legislature in this context must be appreciated, seeing as Indian companies require the burden to be placed on directors due to the very nature of the ownership and management structure.

However, litigants in India rarely invoke this provision or the concept of the business judgement rule and rather, place reliance on safeguards related to oppression and mismanagement. True as that may be, given the intertwined nature of director duties and oppression and mismanagement disputes, progress in jurisprudence around the business judgement of directors would only work to further the company’s and shareholder’s interest and thus, is an option that may be resorted to.

Some have propagated that an intrinsic fairness review be adopted in cases concerning closely held corporations. The intrinsic fairness inquiry discards the application of the business judgement rule in cases where the director shows any “interest” in the transaction. This approach seems reasonable keeping in mind that independence of directors is usually never a reality in closely held corporations seeing as they are always bound to have a material interest in certain transactions. However, seeing as certain elements of the intrinsic fairness inquiry are already present in the Indian context, and the fact that the term “fairness” does not have literature around it, it would be difficult to conclude whether this is the right approach. Thus, we look at other alternatives, one being a pre-cursor to litigation and another, an alternate test that may be adopted by courts while deciding director’s liability.

For the former, the recommended policy change is one that has to do with shareholder voting and their veto powers. European jurisprudence on this matter has suggested that shareholders must be given the opportunity to veto a board’s decision in business matters such as those of takeovers wherein the board is seeking to implement defensive measures. However, the author sees an inherent flaw in this suggestion. If one were to equip shareholders with the power to veto each and every single board decision, it would result in substantial undermining of the board’s expertise and capability to make decisions and essentially take away all its power. Thus, allowing this approach in all situations would eventually end up creating more conflicts within the company itself due to disagreements between the board and the shareholders. Perhaps the only mode through which this would work is if the veto power is limited to certain situations (such as deployment of defensive measures during takeovers), which may be prescribed in a company’s articles of association.

With regards to the next recommendation seeking to instill a new test, the suggestion may not be unique to that of a close corporation, but it is one of the key elements to make note of. The idea that the majority shareholders owe a duty to the minority shareholders, especially when they are in charge of the decision-making process has gained traction over the years. This is perhaps the situation that most accurately depicts the intertwined nature of the business judgement rule and oppression & mismanagement that may occur against minority shareholders. However, to allow this principle to be used as a substitute for the business judgement rule, Indian courts must accept an alternate definition of oppression to mean that oppression represents a situation wherein the “reasonable expectations” of the shareholders are not met. The reasonable expectations of the minority shareholders become relevant in matters of closely held corporations since it is only in such companies, where the shareholder is so concentrated that there is scope for personal trust, relations, and a “special factual relationship” as well, due to which minority shareholders have come to rely on the directors (also being the majority shareholders) to look after their interests. Perhaps the most beneficial feature of the reasonable expectations test is that it places itself in the plaintiff’s position to better understand whether wrongful inconvenience has been caused in a manner that benefits the board of directors. This also simplifies the court’s tasks as they would be tasked with a more objective inquiry.

Conclusion

Given the beneficial nature of the reasonable expectations approach and how it accounts for the relationship between the board of directors and the minority shareholders, it has come to be termed as the perfect fit for closely held corporations. The approach is tailored to meet the requirements of a closely held corporation, unlike the business judgement rule which was meant to cater only to widely or publicly held corporations and also pays heed to the specifics of the company, which allows courts to adopt a flexible application of the reasonable expectations test.. While an entire replacement of the business judgement rule with the reasonable expectations approach may be too radical of a change for courts, it is argued that since the test be incorporated as a criterion that courts apply when suits challenging a director’s actions are brought before them.