Director’s Fiduciary Duty: Understanding the Trust Issues between a Director and a Company

Director’s Fiduciary Duty: Understanding the Trust Issues between a Director and a Company

In this article, we discuss the importance and relevance of fiduciary duties owed by a director to a company in great detail with the help of two case laws. The first case law is a landmark judgment given by the House Of Lords in 1942 on the role of a director and the fiduciary relationship between the director, the company and the shareholders as well to some extent. The second case law from the Delhi High Court talks about the principles followed by the Indian Courts on fiduciary duties. It should also be stated that not abiding by the fiduciary duties might result in information asymmetry between the shareholders and the directors. Thus, the director should always strive to keep up the trust of the company and its shareholders.

2. REGAL (HASTINGS) LTD. V. GULLIVER & ORS., [1967] 2 A.C. 134

HOUSE OF LORDS DECISION

Appellant- A limited company called Regal situated in Hastings.
Respondents- Five Former Directors and a solicitor of the appellant company.
Year- 1942 (Refer to unknown facts).
Bench- House Of Lords (5 Lords).

2.1.RELEVANT FACTS:

DESIRE TO GAIN THE LEASE:

• The appellant company, with first five respondents as directors owned a theatre named Regal. Within a few months of its incorporation, the respondents desired to get the lease of two more competing theatres located in that area in order to gain more reputation.
  CONDITION OF MINIMUM SHARE CAPITAL:
• The landlords of those competing theatres conveyed to the respondents that they would grant the lease only to a company possessing a share capital worth 5000 pounds. (1 pound for each share).

INCORPORATION OF SUBSIDIARY TO GET THE LEASE:

• Thus, in order to lessen the business risk of the company amidst a world war situation, the directors incorporated a subsidiary company named Hastings Amalgamated Corporation with the sole objective to gain the lease of the theatres.

CONTRIBUTED IN PERSONAL CAPACITY DUE TO LACK OF FUNDS:

• While deciding on the funding of the subsidiary company, the appellant company contributed only 2000 pounds due to lack of capital and the rest 3000 pounds was contributed by the respondents in their personal capacity.

SECRET PROFITS ON BEHALF OF THE COMPANY:

• Three weeks later, the respondents sold their 3000 shares and made a profit of approximately 2 pounds on each share with an aggregate profit of approximately 8500 pounds on the whole transaction. The respondents then resigned from the Board of the appellant company.

NON DISCLOSURE TO THE COMPANY:

• The new Board of the appellant company then sued the former directors by issuing a writ against them for non disclosure of secret profits made on behalf of the appellant company and violation of fiduciary duty owed by them to the appellant company. They also asked for damages on account of negligence and misfeasance.

2.2. RELEVANT ISSUES:

• Whether the respondents owed any fiduciary duty to the appellant?
• Whether the respondents earned secret profits solely by using their position and knowledge as directors?
• Whether there was a conflict between the private interests of the respondents with that of the duty owed to the appellant?

2.3. RULE:

• The rule of equity states, that once a person owing fiduciary relationship to a company gains a profit, he/she has to disclose the same to the company. Failure to account for those profits would attract liability. Their personal interests should not conflict with interests of the company.

2.4. PROCEDURAL HISTORY:

THE TRIAL COURT: Justice Wrottesley decided for the respondents.

COURT OF APPEAL: Lord Greene M.R., Justice Mackinnon and Justice Du Parcq L. upeld the decision of the trial court and decided for the repondents.

HOUSE OF LORDS CRITICISING THE REASONING OF THE ABOVEMENTIONED COURTS:

The appellants then appealed to the House Of Lords. The Lords stated that the facts presented to the trial court were obscure and hinting towards the possibility of a fraud. The Trial Court thus stated that since the appellants were unsuccessful in disposing off the burden of proof against the respondents, the plaint is set aside. The issue of fiduciary relationship did not even come into the picture which is the wider aspect rather than the claim on grounds of negligence and misfeasance.

In the Court Of Appeal, Lord Greene stated that the respondents were not acting in a malafide maner as they contributed in their personal capacity only when the funds of the appellant got exhausted . This made them an exception to the general rule on trustees (inclusive of directors) which states that the trustees need to disclose all the profits made by them on behalf of the company. Had they contributed despite the availability of funds with the company, they would have acted in a malafide manner. Thus an absence of fraud was the reason behind their decision which is wrong.

2.5. ARGUMENTS ON BOTH THE SIDES:

APPELLANTS:

• The respondents owed fiduciary duty to the appellant by the virtue of being the directors of the appellant company which they had breached.
• The respondents made profits from the acquisition and sale of shares held by them in Amalgamated since they used their position and knowledge as Directors.
• The directors intentionally omitted to disclose the secret profits to the company made by them on behalf of the appellant.

RESPONDENTS:

• They were under no equity to account for the profits as they fell under an exception to the rule applicable on trustees.
• They acted in a bonafide manner and got the lease for the benefit of the company.

2.6. RATIO DECIDENDI/KEY TAKEAWAY:

The House Of Lords unanimously stated that respondents owed a fiduciary duty towards the company. They should have accounted for the profits made by them by selling the shares of the subsidiary company. However, they came to such a conclusion by the virtue of different reasonings and logic.

2.7. LOGIC BEHIND THE JUDGMENT AND CASES CITED:

LORD VISCOUNT SANKEY:

• While explaining fiduciary duties, he cited the case of Keech Vs. Sandford , which stated that a trustee cannot renew a lease intended for the benefit of an infant under his own name as there might be a conflict of interests in the future. The trustee, in future might refuse to honour the lease in the name of the infant.
• He further cites the case of Ex Parte James and stated that a solicitor cannot buy a bankrupt’s estate due to the fiduciary relationship owed to him. Allowing it would give rise to a conflict of interests between the two.
• By relying on the above mentioned case laws, he states that the respondents were the directors of the appellant during the whole course of time and did not fall under the exception to the rule of trustees. The existence of malafide don’t have to be necessarily proved when the respondents are in a fiduciary relationship with the appellant. The mere non disclosure of secret profits would suffice to hold the respondents liable.

LORD RUSSELL OF KILLOWEN:

• He cites the case of Parker Vs. McKenna , which states that an agent has to dislose the secret profits made on behalf of the company and this is an inflexible rule.
• Relying on the above judgment, he stated that since the respondents, funded the rest of the share capital, it makes them an agent of the appellant at the behest of whom they secured the profits and are responsible to disclose it to the appellant.
• He stated that there is nothing wrong in making such transactions on behalf of the company but the non disclosure of accrual of secret profits is not feasible as per the rule of equity.

LORD MACMILLAN:

• Reiterates the same thing and defines “equity” as prohibiting the Trustee from making any profit directly or indirectly as per the Principles of Equity by Lord Kames.

LORD WRIGHT:

• He stated that since it is difficult to establish malafide, it has been held in law and equity that if a person makes a secret profit out of a fiduciary relationhip, the Court is not obliged to investigate whether the other person is damnified or has lost a profit which otherwise he would have got. The fact is in itself a fundamental breach of the fiduciary relationship.

LORD PORTER:

• He stated that the breach of the fiduciary duty by the respondents has resulted in a large reduction on the amount of profits that might have accrued to the shareholders.

2.8. STATUS OF THE CASE:

• It is a good law as it crystallizes the fiduciary duties owed by the directors to the company.

2.9. USAGE AS A PRECEDENT:

This case has been cited by Indian Courts as well.

• CMS Dolphin Ltd v Paul M Simonet and Another, [2001] 2 BCLC 704).
• Bhullar and others v Bhullar and Another , [2003] 2 BCLC 241.
• Horcal Ltd v Gatland ChD ([1983] BCLC 60).
• Fassihim, Liddiardrams, International Ltd, Isograph Ltd v Item Software (UK) Ltd CA ([2004] EWCA Civ 1244.
• Ultraframe (UK) Ltd v Fielding and others ChD (Bailii, [2005] EWHC 1638 (Ch).
• Devenish Nutrition Ltd v Sanofi-Aventis Sa (France) and others, [2009] 3 All ER 27
• Jones and others v Firkin-Flood ChD (Bailii, [2008] EWHC 2417 (Ch).
• O’Donnell v Shanahan and Another CA (Bailii, [2009] EWCA Civ 751.
• FHR European Ventures Llp and Others v Cedar Capital Partners LlcSC (Bailii, [2014] UKSC 45.
• Halton International Inc (Holding) and Another v Guernroy Ltd ChD (Bailii, [2005] EWHC 1968 (Ch).

2.10 UNKNOWN FACTS:

• Both the Trial Court and the Court of First Instance have cited 0 cases while reaching a conclusion.
• Though the official decision on this case was given in 1942, it was officially reported only in 1967 and the gap between the actual date and the citation was a result of the chaos prevalent due to World War II.

2.11. CRITIQUE/COMMENT:

According to me the case, considering that it was written near the World War II , it has logically answered the question revolving fiduciary relationship but it still fails to lay some guidelines or tests which will help the future judges to objectively pinpoint the existence of a fiduciary duty and a breach of the same.

3. GLOBE MOTORS LTD. V. MEHTA TEJA SINGH & CO.,
DELHI HIGH COURT, (1984) 55 Com Cases 445 (Del).

Appellant- Globe Motors ltd.
Respondents- Mehta Teja Singh & Co.
Bench- Justice Rajinder Sachar and Justice D.R. Khanna
Year- 1984

3.1. RELEVANT FACTS:

• An agreement was entered into by the Appellants (“the Company”) and the Respondents (“the Distributors”) for the sale and marketing of 1/6th of company’s steel on 01.06.1967. This agreement also made a reference to arbitration.
• There were 2 more identical agreements entered into by the Company with other distributors which were ratified in a meeting of the board of directors on the same day the agreement on dispute was approved i.e. 15.06.1967.
• However, it should be noted that 6 out of the 13 directors were direct beneficiaries of these agreements.
• During the process of winding up it was contended by the official liquidator (representing the Company) that the agreement entered on 01.06.1967 should be rescinded as the same was vitiated by fraud and are against the interests of the company.

3.2. RELEVANT ISSUES:

3.2.1 Whether the application filed under Section 20 of Arbitration Act to refer the dispute for Arbitration barred by Limitation?

3.2.2 Whether the agreement dated 01.06.1967 valid?

3.3. RULE:

3.3.1:

• Article 137 of Schedule to Limitation Act,1963
• Section 20, Arbitration Act

3.3.2:

• Section 299, Companies Act, 1956
• Section 294, Companies Act,1956

3.4. ARGUMENTS RAISED BY APPELLANTS:

No arguments raised by the Respondents. They were merely rebutting the arguments of the respondents.

3.4.1 The appellants contended that Section 20 application under Arbitration Act can’t be filed by respondents as it gets barred by Limitation Act and the calculation of the limitation would start from date of first default.

3.4.2 Appellants contend that agreement was invalid as Mr. Harnam Singh (respondent) with whom the agreement was entered into was one of the directors of the company and therefore his interest was involved and there were some other interested directors as well present in the meeting. Further, it was also alleged that not laying of this agreement before the general body of shareholders also constitutes violation of Section 299 and Section 294.

3.5. RATIO DECIDENDI:

It is the duty of Directors to use their best exertions for the benefit of those whose interests are committed to their charge, and that, they are bound to disregard their own private interests whenever a regard to the conflict with a proper discharge of such duty.

3.6. LOGIC BEHIND THE JUDGMENT:

3.6.1 The court held that the limitation period anyway gets renewed with each subsequent default and therefore this is irrelevant to consider whether limitation period would get calculated from repudiation date and hence application is within time and can be referred to Arbitration. Regarding limitation within a particular part of the claim, the court held that the same can be taken up with the arbitrator.

3.6.2 Does agreement violate Section 299 or Section 294?

• The court held that the directors disclosed their interest, acted within scope of AoA and there was no statutory requirement to place agreement before general body of the company. Hence, no violation on ground of Section 299.
• The agreement doesn’t constitute an agreement to appoint a sole selling agent, hence no mandate of Section 294 to put this before general body meeting of shareholders.
  Consideration of the element of ‘fraud’ in actions of Directors
• The judges further found that any ground that would vitiate the agreement can only be the ground of fraud.
• For this, the court examined the nature of fiduciary duty of the directors and referred to various authorities on that. From Vide Palmer’s Company Precedents, 16th Edition, Part I, Page 561 to 564 and cases like Imperial Mercantile Cradi.t Assn. v. Coleman; R’gal v. Gulliver; & Huntinglon Copper Co. v. Henderson, the court concluded that the directors owe the duty like a trustee of the company and this duty needs to be exercised with utmost good faith.
• Some elements of this duty involve a duty to avoid any kind of conflict of interest, to work for the maximum benefit of the company and to act like a reasonable person towards handling all affairs of the company.
• From the case of Liquidator v. P.A. Tendulker the court concluded that the fraud need not be proved in the strictest sense but it would be enough to prove the likeliness of a fraud and losses thereby to be caused to company.
  Test to determine Fraud
• The test to be applied in cases of Fraud is that ‘had the company been a going concern and had some payments in pursuance of this very agreement been made to the respondents could the company have asked for recession of the contract or in case any payments had been made to the respondent Harnam Singh and others, for the return of the same to the company. If the answer is in the affirmative, the claim of the appellant must succeed.’

Determining Fraud

• The present court while discussing the genuineness of the agreement looked into certain facts which were overlooked by the Learned Single judge.
• The Court realized the cost of Rs. 5 lakh which the Single judge considered to be consideration for the agreement was a separate transaction and had nothing to do with the agreement in dispute.
• Further, the court accepted the appellants argument that considering this was a service employment contract none of the respondents had any area of expertise and had never dealt with steel products indicating that the agreement was entered for their personal gain.
• The presence of directors during the approval of the meeting was a mere formality wherein 6 out of 13 directors had personal benefit from the agreements ratified that day.
• The Court also looked into the various articles of the disputed agreement particularly, Article 2 (4) and 4 pursuant to which the distributors would receive the a minimum amount of Rs 1,20,000 p/a as a fee even if no sales has been made and the Company was also required to reimburse the distributors for all the expenses incurred by them for the promotion of the products, which essentially means that nothing was to be spent by the distributors.
• Such a contract as per the Court cannot act in the interest of the Company.
• Disclosure of interest and not voting is only a formal aspect of the compliance with the statutory provision.

Final Decision

• The basic question is as to the conduct of the directors and whether it satisfies the test considering their fiduciary relationship to the company. Therefore, the Court held that the terms of the agreement dated 01.06.1967 were detrimental for the company and the same was used by the directors for their personal benefit without doing any amount of work. Hence the agreement is void and appellants are entitled for the remedy for recession.

3.7 STATUS OF THE CASE:

• It remains a good law and the position has been further enhanced and confirmed in the Section 184 of Companies Act, 2013.

3.8 USAGE AS A PRECEDENT:

• Yashovardhan Saboo vs Groz-Beckert Saboo Ltd. And Ors., 1995 83 CompCas 371 CLB
• Hemant D. Vakil and Ors. vs Rdi Print and Publishing Pvt. Ltd., 1995 84 CompCas 838 CLB
• Rohit Chunubhai Mehta vs Gujarat State Fertilizer Co. Ltd., (2004) 3 GLR 1952
• Commissioner of Income Tax Vs Principal Officer C/O Arkay Wires, 2005 127 CompCas 250 All
• Ledo Tea Co. Ltd. vs Commissioner of Income-Tax, 2000 241 ITR 605 Cal
• B.D.A. Breweries and … vs Cruickshank and Co. Ltd., 1996 85 CompCas 325 Bom
• Motor and General Finance (India) … vs Great Indian Roadlines and Anr.
• National Research Development … vs Shri O.P. Kathpalia
• Magma Leasing Limited vs Hcl Infosystems Limited, 2008 143 CompCas 267 Delhi

3.9 CRITIQUE/COMMENT:

This case showed that when a substantial portion of the board becomes interested in some or the other transaction, even when the interested directors disclose their interest and do not participate in the decision-making, their presence is enough to incentivize the entire board to indulge in back scratching, thereby prioritizing their self-interest over the company’s. Cases like these indicates that there should be a higher threshold for ensuring independence of the board, However, if this case was to be decided as per the amended Companies Act, participation of interested director in the decision-making would itself violate section 184 and render the transaction voidable. In our personal opinion we believe that Globe Motors is a unique fact specific case wherein 6 out of 13 directors acted for their personal benefit, however had the number of directors benefitting would have been less the mere disclosure of interest and interest would be sufficient for the directors to prove their loyalty to the company. The learned Single Judge was convinced because the directors had fulfilled their statutory obligations but failed to analyze the actual terms of the contract. Hence, it should be noted that not the disclosure of interest but also the actual terms of the contract should be looked into in order to maintain a higher threshold for cases of fraud and independency of Board.

Bibliography:-

STATUTES:

• The Companies Act, 1956

CASE LAWS:

• Regal (Hastings) Ltd. v Gulliver and Others, [1967] 2 A.C. 134
• Keech Vs. Sandford, Sel.Cas.Ch. 61.
• ExParte James, 8 Ves. 337
• Parker Vs. McKenna, (1874) 10 Ch.App. 96 .
• Globe Motors Ltd. Vs. Mehta Teja Singh & Co., (1984) 55 Com Cases 445 (Del).
• Imperial Mercantile Cradi.t Assn. v. Coleman, (1873) L.R.61-I.L. 189.
• Regal (Hastings) Ltd. v Gulliver and Others, [1967] 2 A.C. 134.
•  Liquidator v. P.A. Tendulker, (1973) 43 Company Cases 382.