Through the course of law school, we have been taught in various capacities that there exists a distinct separation between ownership and management. Such ownership stands diffused by shareholders and the company is managed by a Board of Directors on behalf of such shareholders, which brings us to the Principal – Agent relationship where the Agent (Board of Directors) represents the interests of the Principal (shareholders) and such directors are expected to make decisions in the bona fide interest of the company. Though directors are agents of the company and not shareholders, the courts have carved out certain exception through the years where the directors also owe a duty to the shareholders. Such duties haven’t been codified in the erstwhile Act and courts relied in precedence to determine whether the act in question is mala fide and devoid of proper purpose. Dale and Carrington is a classic example of the agency problem which was decided by a division bench of the Supreme Court. In this case, the shareholders were kept unaware of crucial ownership and management decisions which led to the dilution of shareholding of the principal shareholder among many other issues. This brief shall delve into the rationale relied upon by the Court in holding the Managing Director liable for acts of oppression and mismanagement.
The ball is set rolling when for personal reasons Respondent decided to acquire a hotel for 6 lakhs and have second Appellant look after the hotel. Towards the management of said hotel, Dale and Carrington Investments was incorporated in 1986 and the hotel was acquired by the company in 1987 wherein 5 lakhs was paid by Respondent and the was paid by the other Respondents and in the process, 5000 equity shares were issued in lieu of this investment made by Respondent which was divided in equal parts between Respondent and his wife, making them principal shareholders of the company.
In 1998, when the respondent decided to come to India he notes that the authorized capital of the company was increased from 15 lakhs to 35 lakhs. In addition to this, in an alleged meeting of the Board of Directors chaired by the second Appellant, it was informed that a sum of 6,86,500/- stood to the credit of the second Appellant and it was subsequently decided that 6865 shares worth 100/- each would be issued towards the amount due.
These very important decisions were made without the knowledge of Respondent who was a principal shareholder of the company and these decisions reduced the Respondent from majority to minority shareholder and to challenge this illegal allotment, Respondent and his wife approached the Company Law Board under S397 and S398 of Companies Act, 1956 and alleged that such allotment amounted to an act of oppression on the part of the second Appellant who was managing the company. The CLB noted that second Appellant had committed an act of oppression by not informing Respondent of issue of further share capital. Interestingly however the CLB while granting relief gave an option to Respondent to sell his shareholding in the company to second Appellant at a return of 12% PA from date of investment.
The Respondent was aggrieved to learn that despite the finding on oppression in his favor, he was asked to sell his shareholding and leave and second Appellant was aggrieved of the finding of oppression against him, resulting in appeals before the Kerala High Court against the decision of the CLB. The HC allowed the appeal of Respondent on question of relief granted and held that second Appellant committed fraud in appointing 6685 shares in his favor and further held that a perpetrator of fraud could not be allowed to benefit from his wrongdoings and ordered the setting aside of allotment of shares made to second Appellant.
Aggrieved by this decision of the Kerala HC, the second Appellant approaches the Supreme Court and while there were multiple issues before the court’s consideration, the relevant issue for matters of our discussion is –
While deciding upon the validity of allotment of shares of company in favor of second Appellant whereby he becomes a majority shareholder and the Respondent and his wife are reduced to minority shareholders the court considers mainly two issues-
1. Whether the allotment of shares was a bona fide act?
2. Whether the directors owe a duty to the shareholders of the company?
In deciding this issue, Court delves into questions of fact while determining whether the meeting where the additional shares were issued was held at all and a perusal of the minutes of the meeting and the lack of evidence to show that notice of such meeting was issued to the directors was enough to show that no such meeting ever took place thereby setting aside the additional allotment of shares. The Court then observed if there existed a need of additional funds for which such shares were issued and noted that none of the documents placed on record indicated such a need and that such act of issuance by second Appellant was done in advancing his own personal interest of taking control over the affairs of the company.
Moving to the question of whether the issuance of additional shares was a bona fide act, the Court highlights the fact that the company is a juristic person and its directors are understood to be its agents, trustees or representatives and that any decision made must be done in utmost good faith and with the exercise of reasonable care and due diligence with the best interest of the company in mind. They have a duty to make honest and timely disclosures to its shareholders on all matters relating to the company. It follows that in the matter of issuance of additional shares, the directors owe a fiduciary duty to issue such shares for a “proper purpose”, a doctrine that was recognized in Hogg v. Cramphorn[1].
The Court places reliance on the judgments in Alexander v. Automatic Telephone Co.[2], Needle Industries Ltd. v. Needle Industries (Newey)[3], Punt v. Symons[4], Piercy v. S. Mills & Co[5] and Hogg v. Cramphorn[6] where all the decisions had one holding in common – in situations where authority exercised towards extraneous purposes such as for maintenance and acquisition of control over the affairs of the company, such actions cannot be upheld whatsoever.
The Court highlights how non-application of S81 of Companies Act to private companies still mandates such directors to make disclosures to shareholders when further shares are being issued and that such requirement flows from their duty to act in good faith. The Court also takes into consideration that share capital in private companies is generally held among close knit-groups and uses the analogy of partnership cases where utmost good faith is owed to each other. The company according to its AoA was intended to be kept as a close-knit group and if the directors contravened such good faith as discussed above they can be held liable for breach of trust for misapplying funds of the company.
The Court further held that if a member who holds majority of shares is reduced to a minority by an act of the company or its directors, such is to be considered as an act of oppression against said member as he is entitled to manage and run the affairs of the company, a benefit that he enjoys by virtue of provisions of law and as a consequence, the allotment of additional shares was set aside.
We see how on deciding upon the acts of second Appellant the Court emphasizes that an action of a director must not just satisfy the bona fide test but must also satisfy the proper purpose doctrine, failing which the action shall not be upheld.
Through this case, we see how jurisprudence around duties of directors has evolved through English and Indian case law. The Legislature recognized that it was necessary to codify such duties of directors, giving us Sections 166(1) – 166(6) of the new Companies Act and with 166(7) providing for penalties for violation of provisions, it has increased the degree of accountability as now it is not only a fiduciary obligation but a statutory duty. If a case like Dale Carrington would now come to court, the shareholder would file not only an application under S241 for oppression and mismanagement but also under section 166(2) which requires the director to act in a bona fide manner and proper purpose, for contravening his statutory duties as the director of the company.
[1] Hogg v. Cramphorn, (1967) 1 Ch. 254; In this case, it was held that if the power to issue shares was exercised for an improper motive, the issue was liable to be set aside and it was immaterial that the issue was made in a bona fide belief that it was in the interests of the company
[2] Alexander v. Automatic Telephone Co., (1900) 2 Ch. 56; “…. directors who so use their powers as to obtain benefits for themselves at the expense of the shareholders, without informing them of the fact, cannot retain those benefits and must account for them to the company, so that all the shareholders may participate in them”
[3] Needle Industries Ltd. v. Needle Industries (Newey), (1981) 3 SCR 698; “So if the Directors succeed, also or incidentally, in maintaining their control over the company or in newly acquiring it, it does not amount to an abuse of their fiduciary power. What is objectionable is the use of such power simply or solely for the benefit of Directors or merely for an extraneous purpose like maintenance or acquisition decontrol over the affairs of the company.”
[4] Punt v. Symons, (1903) 2 Ch 506; “where the shares had been issued by the Directors, not for the general benefit of the company, but for the purpose of controlling the holder of the greater number of shares by obtaining a majority of voting power, they ought to be restrained from holding the meeting at which the votes of the new shareholders were to have been used.”
[5] Piercy v. S. Mills & Co, (1920) 1 Ch. 77; “the basis of both cases is, as I understand, that Directors are not entitled to use their powers of issuing shares merely for the purpose of maintaining their control or the control of themselves and their friends over the affairs of the company, or merely for the purpose of defeating the wishes of the existing majority of shareholders.”
[6] Hogg v. Cramphorn, (1967) 1 Ch. 254
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