Directors’ and shareholders’ duties and derivative action

Introduction

The Delhi High Court in its recent judgement, (Rajeev Saumitra vs. Neetu Singh & Ors), examined the scope of Section 166 of the Companies Act, 2013 (Directors’ Duties), expanded the current understanding of shareholders’ obligations and opened the doors to derivative suits, hitherto largely unknown to Indian shareholders.

Facts

n  The plaintiff and the defendant are shareholders of Paramount Coaching Centre Private Limited (Paramount), each holding 50% of the share capital of Paramount. They are also directors of Paramount. n The defendant has incorporated two other companies that carry out businesses competing with Paramount, in relation to which she solicited the employees and existing clientele of Paramount. In order to promote the activities of the companies incorporated by her, the defendant also made undue use of the goodwill and intellectual property of Paramount.  n As the defendant was a 50% shareholder and director of Paramount, she had the ability to block any resolutions of Paramount seeking to proceed against her. In light of this, the plaintiff reasoned that he had no alternative but to pursue a derivative suit against the defendant for the breach of Section 166 of the Companies Act, 2013.

Judgement

This case is one of the first to examine directors’ duties as codified pursuant to Section 166 of the Companies Act, 2013, and the maintainability of derivative suits in India. In this regard, of particular interest are the following observations of the court: Duties of a director The court, on the basis of the facts of the case, held that the defendant, being a director and majority shareholder of Paramount, had not acted in good faith and her actions were in violation of her fiduciary duties as a director. Being guilty of the breach of Section 166 of the Companies Act, 2013, she is liable to repay to the company, the undue gain already made (through the newly incorporated competing entities).  Maintainability of derivative actions n A derivative suit is filed by a shareholder in their own name, on behalf of the company and for the benefit and advantage of such a company, against a third party (which includes ‘insiders’ such as directors or other majority shareholders) who may be acting against the company’s interests. In a derivative action, the benefit of the action and the remedy, if any, is intended for the company and not the individual shareholder initiating the action. n The court held that a breach of directors’ duties would give the plaintiff shareholder the right to pursue derivative action against the defendant on behalf of Paramount. Duties of shareholders Pursuant to the defendant’s status as a majority shareholder of Paramount, the court observed, “It is true that a share is property, which its owner may treat in any way he desires. These options, however are not unlimited … A controlling shareholder who wishes to sell his shares owes a duty of loyalty to the company with respect to the sale, and must act in good faith and honesty toward it, and he will be in breach of his duty if he sells his shares to a buyer who to the best of his knowledge will strip the company of its assets and lead to its insolvency.”

Implications

n The court recognized that it was treading new ground in corporate governance and advised of the need to proceed with caution. While the judgement is heavily reliant on the facts of the case, Justice Manmohan Singh states, “Ordinarily the directors of the company are the only persons who can conduct litigation in the name of [a] company, but when they are themselves the wrongdoers … and have acted malafide or beyond their powers … the majority of shareholders must in such a case be entitled to take steps to redress the wrong.” This opens the door for pursuing derivative suits and acts as an added course of action for shareholders, in addition to the yet-to-be-notified class action suit provisions set out in the Companies Act, 2013. n Further, the prohibition on directors competing with the business of the company in which they hold directorship will need to be examined further. It remains to be seen whether the actions of nominee directors and/or directors who are resigning will be subject to the same scrutiny as applied in this case. n The duty of shareholders, particularly the majority shareholders, to ensure that the sale of their controlling stake does not result in the stripping of the company also raises questions in relation to the maintainability of commonly employed M&A/private equity exit provisions such as drag rights and the right to make strategic sales.